According to media reports who have spoken to individuals with firsthand knowledge of the situation, the Securities and Exchange Commission (“SEC”) is reportedly conducting an industry-wide inquiry into the policies and safeguards of cryptocurrency exchanges on matters relating to insider trading prevention.1 The SEC has reportedly contacted at least one major cryptocurrency exchange seeking information about the organization’s insider trading policies. Since the SEC does not comment on its investigations, we would not expect the SEC to confirm or even deny these reports.
Given the volatility in the cryptocurrency market, as well as the potential for astronomical gains or losses trading cryptocurrencies and other digital assets, the alleged sweep may signal yet another aspect of the SEC’s continued regulatory scrutiny of the cryptocurrency industry.
The Lead Up to the SEC’s Reported Investigation
As background, as has been the case with capital markets throughout the world, the global cryptocurrency market declined significantly in overall value during recent months. These declines have included sharp drops in the value of several well-known cryptocurrencies. Recent months have also seen several high-profile setbacks within the industry. For example, certain large cryptocurrency projects experienced severe liquidity issues, raising broader concerns about system-wide risks that have the potential to impact the cryptocurrency market. SEC Chairman Gary Gensler has placed some of the blame for this instability on cryptocurrency exchanges themselves, accusing them of acting against the interests of their clients.2
Against this backdrop of market turbulence, there reportedly have also been allegations of insider trading incidents within the cryptocurrency industry. These claims center around allegations that those trading or even just holding cryptocurrencies are buying and selling those instruments while in possession of material non-public information and prior to that information’s public dissemination. Insider trading liability arises primarily from SEC Rule 10b-5, which is violated when (1) “a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information” or (2) an outsider “misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”3 A recipient of insider information is liable if they knew or should have known of the tipper’s fiduciary duties, and the tipper is liable if they received some personal benefit from the transaction.4 In public statements, Chairman Gensler has emphasized that, despite the novel aspects of cryptocurrencies, they are still subject to securities regulations if they represent “a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”5 This definition embodies what is frequently referred to as the “Howey Test,” named after the seminal Supreme Court decision that established the governing standard for determining when an instrument is an “investment contract” (and, therefore, a security).6
Unresolved Questions, But Demonstrated Proof of Cryptocurrency Enforcement Focus
What remains to be seen is whether this alleged SEC inquiry into the insider trading policies of cryptocurrency exchanges reflects (i) specific concerns from the SEC as to the efficacy of insider trading protections within the industry or (ii) a more general review of industry safeguards as part of the SEC’s regular information-gathering function. Whichever focus the SEC takes in its inquiry, it is taking place as the SEC is undoubtedly increasing its scrutiny over cryptocurrency markets. For example, the SEC has recently settled an enforcement action with BlockFi, one of the largest crypto lending exchanges, resulting in BlockFi paying US$100 million in penalties for violating the registration provisions of the Investment Company Act of 1940.7 In May, the SEC announced that it had nearly doubled the size of the Division of Enforcement’s Crypto Assets and Cyber Unit, which is tasked with investigating securities law violations related to crypto asset exchanges. Since the Crypto Assets and Cyber Unit’s announcement, the SEC has announced two more enforcement actions taken against actors in the cryptocurrency industry.8
But, the SEC’s intense focus on the cryptocurrency industry has not progressed without industry pushback. For example, just this week, Grayscale Investments, the world’s largest digital currency asset manager, announced that it filed a petition for review with the United States Court of Appeals for the District of Columbia Circuit challenging the SEC’s decision to deny conversion of Grayscale Bitcoin Trust (BTC) (OTCQX: GBTC) to a spot Bitcoin ETF.9 As Grayscale’s CEO put it, “we are deeply disappointed by and vehemently disagree with the SEC’s decision to continue to deny spot Bitcoin ETFs from coming to the U.S. market.”10 He continued, “[t]hrough the ETF application review process, we believe American investors overwhelmingly voiced a desire to see GBTC convert to a spot Bitcoin ETF, which would unlock billions of dollars of investor capital while bringing the world’s largest Bitcoin fund further into the U.S. regulatory perimeter.”11 Grayscale’s CEO emphasized, “[w]e will continue to leverage the full resources of the firm to advocate for our investors and the equitable regulatory treatment of Bitcoin investment vehicles.”12
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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