Will the SEC Convince a Court It’s Right to Label These Tokens as Securities?

The U.S. agency’s insider-trading case against a former Coinbase manager hinged on nine tokens it classified as securities, but the ex-employee’s lawyers are saying it’s not so.

AccessTimeIconFeb 8, 2023 at 1:00 p.m. UTC
Updated Feb 8, 2023 at 6:46 p.m. UTC
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Lawyers have challenged a potentially consequential move from the U.S. Securities and Exchange Commission (SEC) to build a list of crypto tokens it considers unregistered securities.

Nine tokens – most of which traded at Coinbase (COIN) – were featured by the regulator in an insider-trading case against a former manager at the company. Many believe that maneuver has importance well beyond the enforcement action, because the cryptocurrency industry has been eager to settle the question of which digital assets may be regulated by the SEC as securities and which may be commodities regulated by the Commodity Futures Trading Commission (CFTC). The SEC appeared to be slowly answering that question token by token.

Now the regulator will have to defend the assertion in federal court that the nine tokens tied to the case should be considered securities, because lawyers for the ex-Coinbase employee, Ishan Wahi, filed an argument this week that the tokens weren’t securities and the agency shouldn’t be using one person’s enforcement action to decide “how major questions of law that loom over entire industries should be resolved.”

The SEC “is trying to seize broad regulatory jurisdiction over a massive new industry via an enforcement action against a 32-year-old former Coinbase employee and his kid brother,” the filing said.

The basis of their motion to dismiss the SEC’s charges is that the tokens – including Flexa’s AMP, RLY, POWR and LCX – don’t qualify under the legal definitions of securities.

“The term ‘investment contract’ requires – as the statute says – a contract,” the lawyers wrote. “But here there are no contracts, written or implied.”

The court filing contends that the tokens’ investors weren’t throwing their money into an “enterprise,” but just buying assets from a third party.

“The tokens’ value is driven by market forces, not managerial efforts – as evidenced by the fact that the tokens are almost all functional (i.e., they can operate without any centralized intermediary) and that each experiences wide price fluctuations, regardless of the status of the underlying platform,” according to the motion.

However, crypto commentator Bennett Tomlin noted on Twitter that the argument is “weak” that the tokens don’t rely on the entities behind them, suggesting, for instance, that “LCX very much relies on LCX dot-com.”

Another project, Rally, shut down its entire sidechain last week, stranding users’ non-fungible tokens, though the RLY token itself seemed unaffected.

A spokesman for the SEC didn’t immediately respond to a request for comment, nor did spokespeople from Coinbase.

“In the absence of a concrete digital asset securities regulatory framework from the SEC, we remain confident that Coinbase’s rigorous review process keeps securities off Coinbase’s platform,” the company’s chief legal officer, Paul Grewal, wrote in a blog post last year after the SEC’s action.

Patrick Daugherty, a lawyer who worked at the SEC and now represents crypto clients at Foley and Lardner in Chicago, called the latest filing an “exceptionally fine articulation of lawyerly objections to the progressive-left power grab that we are sadly witnessing in current SEC leadership.”

“One can only hope that the new chairman of the House Financial Services Committee will get some control over this wayward federal agency and that lower federal courts will recognize abuse of power when it’s pointed out to them,” said Daugherty, who also teaches about crypto at Cornell University’s law school.

As of last month, Rep. Patrick McHenry (R-N.C.) is running the House committee that oversees the SEC, and he’s made it clear that he’s planning heavy criticism for the way SEC Chair Gary Gensler is running the agency.

However, Kevin Werbach, a professor at the Wharton School at the University of Pennsylvania, isn’t convinced that this case will provide a significant legal framework for the SEC’s security definitions and may just be about proving one person’s violation of securities laws.

“I wouldn’t expect Wahi, which addresses the issue only indirectly, to be the central case in this area,” Werbach said in an email, saying the legal fight against Ripple will have the greatest weight. “The pending Ripple case, which has been very aggressively litigated, will either further reinforce the SEC’s position or throw a monkey wrench in the whole operation.”

Still, lawyers representing the crypto industry have been carefully studying any assertions from the agency that a crypto asset falls into the securities bucket. That situation rose again recently when the SEC labeled FTX’s exchange token, FTT, as a security, creating wider concerns that similar tokens issued by platforms such as Binance would be considered securities by that same logic.

The assertion shouldn’t surprise anyone who has tuned in to Gensler’s remarks.

“Of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities,” he said last year. The only digital asset his agency freely admits doesn’t fall into that category is bitcoin.

CORRECTION (Feb. 8, 2023, 18:45 UTC): Corrects story to clarify that not all nine of the securities flagged by the SEC traded at Coinbase.


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Jesse Hamilton

Jesse Hamilton is CoinDesk's deputy managing editor for global policy and regulation. He doesn't hold any crypto.

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