Insider Trading Laws: Do They Apply To Cryptocurrency?

Cryptocurrency has become an increasingly popular investment vehicle, with retail investors taking an interest in Bitcoin and other cryptocurrencies. However, the rules and regulations governing the trading of these digital assets are still evolving and can be murky, especially when it comes to insider trading. In the United States, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have asserted jurisdiction over cryptocurrencies, treating them as securities or commodities. This means that insider trading laws may apply to cryptocurrency, and traders need to be aware of the relevant regulations to avoid legal trouble and unwanted attention from regulators. While the exact application of insider trading laws to cryptocurrency is still uncertain, it is clear that regulators are watching, and the consequences of non-compliance can be severe.

Cryptocurrency as a security or commodity

The classification of cryptocurrencies as securities or commodities has significant implications for the regulatory framework and the future of the cryptocurrency industry. While securities are subject to stricter regulatory oversight, commodities are regulated less stringently.

Cryptocurrencies as Commodities

Crypto industry executives and proponents argue that cryptocurrencies should be considered commodities. They contend that cryptocurrencies serve as a store of value, similar to commodities like gold, and are used for speculative purposes, hoping to profit from price swings. Another key argument against considering cryptocurrencies as securities is their decentralized nature. The Howey test, which determines whether an asset is a security, specifies that a security involves investing in a common enterprise and profiting from the efforts of a third party. The lack of a centralized entity underlying cryptocurrencies suggests they should be classified as commodities.

Cryptocurrencies as Securities

Although crypto advocates generally argue against the more stringent regulations that would come from classifying cryptocurrencies as securities, doing so may make these assets more attractive to a wider range of investors. For instance, when blockchain or crypto-related companies raise capital through initial coin offerings (ICOs), they issue digital coins that allow investors to participate in the crypto project and earn a share of its profits. Therefore, ICOs resemble the initial public offerings (IPOs) that companies use to bring their stock onto the public markets, suggesting they should be regulated as securities.

The Regulatory Landscape

The debate over whether cryptocurrencies are commodities or securities remains unresolved. The intricacies of the question may make a one-size-fits-all solution impractical, with some cryptocurrency tokens presenting characteristics more akin to commodities, while there are valid arguments for considering others as securities.

In the United States, the Securities and Exchange Commission (SEC) regulates securities, while the Commodity Futures Trading Commission (CFTC) oversees commodities. The determination of whether a cryptocurrency is a security or a commodity falls within the purview of these regulatory bodies.

The Commodity Futures Trading Commission (CFTC) considers Bitcoin a commodity and has asserted regulatory authority over it under the Commodity Exchange Act. Similarly, in a lawsuit against Binance, the CFTC explicitly declared that Ethereum, Bitcoin, and Litecoin are commodities. On the other hand, the SEC has applied the Howey Test and argued that certain crypto tokens, such as Ripple's XRP, are securities subject to associated regulations.

The classification of cryptocurrencies as securities or commodities has significant implications for regulatory compliance, investor confidence, market stability, and the growth of the cryptocurrency industry. Crypto companies must properly classify their tokens to ensure full compliance with regulatory requirements. Misclassifying a cryptocurrency can result in regulatory scrutiny, enforcement actions, fines, and legal liabilities for issuers, investors, and exchanges.

Insider trading laws in the US

Insider trading is the buying or selling of a company's securities by individuals who possess material, non-public information about that company. It is a contentious issue in financial markets and has been illegal in the US since the 1930s. The Securities Exchange Act of 1934 was the first legislation in the country to ban the practice.

The SEC defines an insider as "an officer, director, 10% stockholder and anyone who possesses inside information because of his or her relationship with the Company or with an officer, director or principal stockholder of the Company." Trading by such individuals based on non-public information is illegal.

There are three main types of insider trading: classic liability, tipper liability, and tippee liability. Classic liability occurs when an employee or director trades on material, non-public information from the company they work for. Tipper liability involves a company insider communicating confidential non-public information to a trader. Tippee liability, on the other hand, is when a trader actively seeks and trades on material, non-public information from a source with a confidential duty.

It is important to note that not all trading that stems from material, non-public information violates security laws. For example, if someone overhears a conversation about an impending transaction between two corporations in a public setting, they are not bound by a duty of confidentiality and can trade based on that information.

The SEC requires insiders to file reports of their trades, which are publicly available. These reports can be accessed through the SEC's Electronic Data Gathering, Analysis, and Retrieval system and its SEC Insider Trades Datasets.

The penalties for insider trading can be both civil and criminal, depending on the severity of the offense. The SEC can impose civil fines of up to three times the profit gained or loss avoided due to the insider trading. Individuals found guilty are also required to return any ill-gotten gains. In addition, the SEC can seek court orders to prohibit those found guilty from serving as officers or directors of public companies.

Insider trading can also lead to criminal prosecution, with individuals facing imprisonment of up to 20 years for each violation. Criminal fines can be imposed on top of imprisonment, with individuals facing fines of up to $5 million and corporations facing fines of up to $25 million per violation under the Securities Exchange Act of 1934.

In the context of cryptocurrency, the question of whether insider trading laws apply is more complex. Crypto assets are supported by open-source software, and in the early days of cryptocurrency, it was argued that material, non-public information did not exist in this context. However, as the crypto world has evolved beyond just open-source digital currency, this argument has become less convincing.

US regulators have increasingly prioritized enforcement of insider trading laws in the cryptocurrency space. The SEC and CFTC have asserted jurisdiction over initial coin offerings (ICOs) and virtual currency derivatives, respectively. While the question of whether a given cryptocurrency product is a security, commodity, currency, or something else is still being debated, traders and issuers must remain diligent in their compliance and regulatory obligations.

In summary, insider trading laws in the US are complex and cover a wide range of activities. These laws are enforced by the SEC and CFTC, and violations can result in significant civil and criminal penalties. In the cryptocurrency context, while there is ongoing debate about the applicability of insider trading laws, regulators are increasingly targeting this space for enforcement.

Classic liability

In a classic liability case, the insider is breaching their fiduciary duty to the company and its shareholders by using their privileged position for personal gain. This duty arises from the relationship of trust and confidence between the insider and the company.

To prove classic liability, it must be shown that the insider had access to non-public information, understood that this information was not meant to be used for trading decisions, and still chose to trade or tip based on that information.

Tipper liability

It is important to note that tipper liability is generally derivative of the claims against the tippee. In other words, the tippee's liability for insider trading is dependent on the tipper having breached their fiduciary duty. However, there have been cases where the tippee has been found guilty of insider trading while the tipper was acquitted, as seen in the case of US v. Klundt and Sargent.

To avoid tipper liability, individuals should refrain from communicating material non-public information to others, especially if it is reasonably likely that the other person will trade based on that information. It is also important to be cautious when sharing information in chat rooms or online forums, as it can be difficult to determine the source of information and whether it is being shared in violation of a duty of confidentiality.

Tippee liability

In the United States, tippee liability was first recognised by the Supreme Court in *Dirks v. SEC*. The Court held that a tippee can only be held liable if the tipper breached their fiduciary duty to the company by disclosing the information and received a "personal benefit" from doing so. This personal benefit must be objective, consequential, and represent [ing] at least a potential gain of a pecuniary or similarly valuable nature.

The tippee must have known or had reason to know that the tipper breached their duty and received a personal benefit from the disclosure. In other words, the tippee must be aware that the information was confidential and obtained through the tipper's breach of duty.

It's important to note that the tippee's liability is considered derivative of the tipper's breach. This means that the tippee essentially assumes the tipper's fiduciary duty to the company by trading on the inside information.

However, there has been some disagreement and confusion regarding the scope of tippee liability, particularly in cases where the tippee is several steps removed from the original source of information. A notable example is the case of *United States v. Newman*, where the Second Circuit narrowed the interpretation of tippee liability, requiring proof of a "meaningfully close personal relationship" between the tipper and tippee that indicates a potential gain for the tipper.

In response, the Supreme Court clarified the standards for tippee liability in *Salman v. United States*, unanimously concluding that a tipper's gift of inside information to a friend or relative is sufficient to establish personal benefit, even without a pecuniary gain. However, the Court refrained from adopting a very broad interpretation, leaving some uncertainty about the scope of tippee liability.

To summarise, tippee liability in the context of insider trading laws holds individuals responsible for trading on confidential, non-public information received from corporate insiders. The tippee's liability is derived from the tipper's breach of fiduciary duty, and the tippee must be aware of this breach and the tipper's personal benefit. However, the exact scope of tippee liability remains a subject of ongoing discussion and clarification by courts.

Frequently asked questions