The SDNY’s early ventures into crypto-insider trading cases

December 2022  |  SPECIAL REPORT: WHITE-COLLAR CRIME

Financier Worldwide Magazine

December 2022 Issue

It has been a volatile year for emerging digital currencies. As some crypto platforms find themselves occasionally halted due to significant instability and pundits question whether bitcoin is dead, it is not clear just how significant a role currencies that exist as a result of cryptography and decentralised accounting methods will play in the economy in the future.

What is clear is that whether crypto proves faddish or comes to dominate everything from retail transactions to large scale economic activity, digital currencies have begun to leave an indelible impact on the American legal scene. As of this writing, the US Securities and Exchange Commission (SEC) leads a pack of American regulators grappling with which agents and what sort of regime should provide regulatory structure to what has been, in the words of Gary Gensler, chairman of the SEC, a “Wild West” in its early stages.

The questions of to whom the principle Web3 regulatory mantle should fall implicates a number of fascinating, almost metaphysical questions. Which cryptocurrencies, if any, can properly be called securities? And how does one appropriately regulate a digital technology whose very existence is the product of a desire for anonymity?

As the regulatory backdrop for Web3 evolves and eventually congeals, enforcement entities are not waiting for regulators to resolve those questions in full. Traditional Wall Street law enforcement watchdogs have aggressively slid into the cryptocurrency space, mostly by using the tools already available to it. At the head of the parade has been the US Attorney’s Office for the Southern District of New York (SDNY), the Department of Justice outpost that has long led on matters related to investor protection owing to New York’s financial district’s presence within its borders (more than one appointed US attorney in that district has been nicknamed, almost by default, the “Sherriff of Wall Street”).

In recent months, the SDNY has initiated a number of criminal actions against actors in the cryptocurrency space. In reviewing some of these early cases, one can sense a number of thematic winds propelling the SDNY’s sails into this new territory. The SDNY has consciously avoided getting caught in the metaphysical mire of what may or may not constitute a security. Rather, thanks in large part to the flexible criminal statutes at its disposal, the SDNY has focused less on what the digital asset at issue might be, and more exclusively on whether there is a fraud concerning its being offered to the public that can be proven. In any given case, one can call the item at issue a security, a commodity, a token or some amalgam of the three. So long as there is an actionable lie, just call the SDNY ready to plant its flag.

United States v. Wahi et al

On 21 July 2022, the SDNY and the SEC announced parallel insider trading charges against three individuals for allegedly perpetrating a tipping scheme to trade multiple crypto assets ahead of public announcements that the assets would be listed (or made available to trade) on Coinbase, one of the largest crypto asset trading platforms in the US. In a press release that billed Wahi as the “First Ever Cryptocurrency Insider Trading Scheme”, the SDNY US attorney declared that, “Today’s charges are a further reminder that Web3 is not a law-free zone”.

As alleged by both the SDNY and the SEC, typically the prices of crypto assets identified in Coinbase’s public listing announcements would appreciate quickly and significantly following these announcements. As such, Coinbase’s policies defined material non-public information (MNPI) to include “information about a decision by Coinbase to list, not list, or add features to a digital asset (separately defined to include tokens)”. The policies further prohibited Coinbase employees from disclosing MNPI to any other person, including family and friends, or tipping others who might make a trading decision using that MNPI. As alleged, one of the defendants, a Coinbase project manager with access to what listings were upcoming, tipped personal contacts in advance of those listings. The resulting favourable trades by the tippees, over the course of over a year, generated more than $1m in favourable profits.

The SDNY and the SEC did not bring the same charges. The SEC, as it must do by statute, alleged that the defendants violated the securities laws. As such, it alleged that certain of the tokens at issue were securities under SEC v. Howey Co (1946), the US Supreme Court case that established the test that determines whether a given offering is a security. Over the course of the SEC case’s life, the litigation (including discovery) on that point alone may well consume years.

The SDNY, which could have elected to wade into similar territory by charging Title 15 securities fraud, sidestepped it entirely. Instead, the indictment issued in the criminal case charged a relatively modest and straightforward wire fraud theory, charging the defendants with participating in a scheme to deprive Coinbase of its use of confidential business information. Such a theft-based theory is utterly agnostic as to whether the items listed by Coinbase are securities. The appeal of the theory to prosecutors is simple: it is safe, as it is not dependent on potentially volatile issues of what constitutes a security. The theft theory, relying as it does on a duty to maintain secrecy, has many of the trappings of an insider trading case without the requirement of proving that a security was involved.

United States v. Chastain

The SDNY took a similar approach the previous month when it charged a former product manager at Open Sea, the largest online marketplace for the purchase and sale of non-fungible tokens (NFTs), with wire fraud and money laundering. On 1 June 2022, the SDNY unsealed an indictment charging Nathaniel Chastain in connection with a scheme in which he allegedly secretly purchased NFTs that were about to be featured on Open Sea’s homepage, information that he had access to as a product manager and was duty bound not to exploit for personal gain. Much like with Coinbase, when NFTs were featured on Open Sea’s homepage, an increase in the price buyers were willing to pay typically followed. Mr Chastain purchased dozens of NFTs before they were featured on Open Sea, selling them at two- to five-times his initial purchase price.

As with the Wahi case, the SDNY charged wire fraud rather than securities fraud, its traditional statutory marker for insider trading. And as with Wahi, the SDNY’s fraud theory concerned the misappropriation of confidential business information, in violation of duties owed to Mr Chastain’s employer. The case had the trappings of a classic insider trading case, minus the presence of any security.

Another key feature that distinguished Chastain from most SDNY insider trading cases is the absence of a parallel case filed by the SEC. Almost every traditional insider trading case filed by the SEC comes with the simultaneous announcement of civil enforcement charges filed by the SEC. In this case, one can surmise that the nature of the NFTs posted on Open Sea was sufficiently far from a security – or at least that the issue presented substantial litigation risk – such that the SDNY’s customary partners in battling insider trading sat the case out entirely.

The SEC, jurisdictionally bound to securities fraud prosecution, was not in position to pursue a case. The SDNY, limited only by the need to demonstrate some actionable fraud, had a freer hand to prosecute the conduct at issue in Chastain. And at the end of the day, the lack of a security did not prevent the SDNY from trumpeting the charges as a continuation of ancient insider trading prosecution principles, as Williams stated that “NFTs might be new, but this type of criminal scheme is not”.

Conclusion

Technology has produced an array of digital assets with the potential to stymie regulators, at least until new rulemaking is complete. The SDNY has found mobility in getting back to first principles – avoiding almost entirely the thorny questions of what these assets are and using the wire fraud statute to focus instead on what has been done with them. That approach has fuelled its first wave of NFT and crypto insider trading criminal cases and rendered them largely uncontroversial in a fashion that might complicate life for regulators whose territory is defined by the presence of traditional securities fraud.

 

Martin S. Bell is a partner at Simpson Thacher & Bartlett LLP. He can be contacted on +1 (212) 455 2542 or by email: martin.bell@stblaw.com.

© Financier Worldwide

BY

Martin S. Bell

Simpson Thacher & Bartlett LLP

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