On June 6, 2023, the Securities and Exchange Commission (SEC) charged Coinbase, Inc. and Coinbase Global, Inc. (Coinbase) with violations of the Securities Exchange Act of 1934 ("Exchange Act") and the Securities Act of 1933 ("Securities Act"). Coinbase is the largest cryptocurrency exchange in the United States and has a market capitalization of roughly $24 billion. The SEC's 101-page complaint, filed in the U.S. District Court for the Southern District of New York, alleges that Coinbase operates as an unregistered national securities exchange, broker, and clearing agency. The SEC further alleges that Coinbase failed to register the offer and sale of its crypto asset stakingas-a-service program under Section 5 of the Securities Act, and that the Coinbase Wallet and Coinbase Prime services offered by Coinbase constitute broker services under the federal securities laws.

The SEC's case against Coinbase is the latest front in the ongoing regulatory battle over digital assets regulation: specifically regarding centralized exchanges that allow buyers and sellers to engage in secondary market transactions in digital assets. The key issues in the Coinbase litigation revolve around whether Coinbase, in providing exchange and related services, must register as an exchange, broker, and clearing agency pursuant to the Securities Act and the Exchange Act. More generally, the Coinbase litigation raises questions about when digital assets and related services, such as staking and interest earning programs, are securities transactions subject to federal securities laws and SEC regulation.

I. BACKGROUND: DIGITAL ASSETS AND THE FEDERAL SECURITIES LAWS

To understand the issues raised by the Coinbase litigation, one must start with how the SEC and the federal courts have defined the financial instruments regulated by the federal securities laws. The definitions of "security" employed by the Securities Act and the Exchange Act are broad and include a laundry list of examples, including stocks, bonds, options, fractional interests, investment contracts, and more.1 Digital assets are not currently included expressly, but they potentially fall within the meaning of "investment contracts." Under the four-part test established by the U.S. Supreme Court in SEC v. W.J. Howey Co. (1946) (the "Howey Test"), an investment contract exists when there is: (1) an investment of money (2) in a common enterprise (3) with an expectation of profit (4) in reliance on the efforts of others.

The breadth and flexibility of the Howey Test are key features. In articulating this test, the Supreme Court held that the test fulfills "the statutory purpose of compelling full and fair disclosure relative to the issuance of 'the many types of instruments that in our commercial world fall within the ordinary concept of a security.' "2 The adoption of a flexible definition for investment contract extends investor protections to a wide variety of commercial transactions beyond the examples listed specifically in the Securities Act and the Exchange Act, but this choice comes at a cost. The application of a flexible, fact-specific test forces courts to apply a complex, case-by-case analysis that can give rise to a regulatory landscape in which similarlysituated litigants obtain different results in different courts.3 That outcome seems especially likely in the digital assets contexts, as courts grapple with how best to apply Howey to new financial products borne of new technologies that may not offer clear analogies to traditional securities.

The SEC has consistently asserted that Howey grants the Commission broad authority to regulate digital assets. The SEC first took this position officially when it issued a July 2017 Report of Investigation relating to German company Slock.it, the creator of a Decentralized Autonomous Organization ("DAO") used to issue and sell DAO tokens. The sale of DAO tokens generated funds that the DAO used to acquire assets and fund projects that generated returns for DAO token holders. Meanwhile, DAO token holders also could engage in secondary market trading of their tokens via several online platforms. The SEC investigated Slock.it and its cofounders following a 2016 cyberattack against the DAO. While the SEC chose not to take any enforcement action, the Commission published an investigation report asserting that the DAO tokens were regulated securities. Applying the Howey Test, the SEC stated that the tokens were securities because token purchasers had invested money (i.e., Ether) with a reasonable expectation of profits to be made from the projects that required "significant managerial efforts" by Slock.it and its cofounders.4 The SEC also took the position in the DAO investigative report that the platforms used to trade DAO tokens were exchanges within the meaning of Rule 3b-16(a), were not subject to exemptions, and had to be registered as such pursuant to Sections 5 and 6 of the Exchange Act.5

Some two years after the DAO investigation report, the SEC presented a more detailed explanation of its Howey approach in its 2019 "Framework for Investment Contract Analysis of Digital Assets" (2019 Framework). Among other topics, the 2019 Framework focuses at length on how the SEC determines whether a purchaser has a reasonable expectation of profits derived from the efforts of others. The 2019 Framework indicates that in applying Howey, the SEC will seek to determine whether (a) the purchaser reasonably expects to rely on the efforts of a promoter, sponsor, or other relevant third parties; (b) these third-party efforts are significant and managerial rather than ministerial; and (c) the purchaser reasonably expects profits, e.g., capital appreciation, resulting from the development of the initial investment or business enterprise, or a participation in earnings resulting from the use of purchasers' funds, not mere price appreciation resulting solely from the supply and demand for the underlying asset. The 2019 Framework provides that secondary sales or offers of digital assets are subject to the same analysis as an initial sale, plus additional considerations relating to the ongoing efforts of others.

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Footnotes

1. See 15 U.S.C.A. § 77b(a)(1) (defining "security" for purposes of the Securities Act) ("The term 'security' means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a 'security,' or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing." See also 15 U.S. Code § 78c(a)(10) (defining "security" for purposes of the Exchange Act).

2. S.E.C. v. W.J. Howey Co., 328 U.S. 293, 299, 66 S. Ct. 1100, 90 L. Ed. 1244, 163 A.L.R. 1043 (1946) (citing H.Rep.No.85, 73rd Cong., 1st Sess., p. 11) (further providing that the Howey Test "embodies a flexible rather than a static principle" that is "capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits").

3. See Miriam R. Albert, The Howey Test Turns 64: Are the Courts Grading this Test on a Curve?, 2 Wm. & Mary Bus. L. Rev. 1, 8 (2011) (available at https://scholarship.law.wm.edu/wmblr/vol2/iss1/2) ("Indeed, the specter of inconsistent interpretation and/or application by the lower courts arguably threatens to undermine the utility of the Howey test itself as a trigger for investor protection.")

4. Securities & Exchange Commission, Release No. 81207 (Jul. 25, 2017) (https://www.sec.gov/litigation/investreport/34-81207.pdf), at 12.

5. Id. The Exchange Act prohibits brokers, dealers, and exchanges from effecting or reporting securities transactions on a national securities exchange unless the security and the exchange are registered or are exempted from registration requirements. See 15 U.S.C.A. § 78e. Under Section 3(a)(1) of the Exchange Act, an "exchange" is "any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood. . . ." Exchange Act Rule 3b-16(a) further provides that an organization, association, or group of persons shall be considered to constitute, maintain, or provide "a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange," if such organization, association, or group of persons: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade. 15 U.S.C.A. § 78c(a)(1).

6. See William Hinman, Director, Division of Corporate Finance, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018) (https://www.sec.gov/news/speech/speech-hinm an-061418). In S.E.C. v. Ripple Labs, Inc., 540 F. Supp. 3d 409 (S.D. N.Y. 2021), the court issued a summary judgement order ruling that at least certain kinds of digital assets transactions are not securities transactions. In the order, the court applied the Howey Test and held that institutional buyers which "knowingly purchased XRP directly from Ripple pursuant to a contract" had engaged in securities transactions; "programmatic buyers" who purchased XRP via a blind sale mechanism did not engage in securities transaction because, unlike the institutional investors, they did not purchase XRP with a reasonable expectation of profit in reliance on the managerial efforts of Ripple. The court further held that Ripple's issuance of XRP to employees and other third parties did not involve the investment of money, and were not securities under the Howey Test for that reason. The Ripple order does not address whether secondary sales of cryptocurrencies or tokens, including sales on exchanges, would be considered sales of securities, though it does suggest, through its holding on ''programmatic buyers'', that secondary transactions on exchanges via a blind sale mechanism would not be securities transactions. Prior to Ripple, courts addressing whether the offer and sale of digital assets are securities transactions have generally found that they are. Given the nature of the Howey Test, these findings are generally fact-specific and have not given rise to a general rule for the evaluation of digital assets. See, e.g., SEC v. Kik Interactive, Inc., Case No. 19-cv-5244 (AKH) (Oct. 21, 2020) (final judgment resolving SEC charges that Kik's unregistered "Kin" token offering violated the federal securities laws); S.E.C. v. Telegram Group Inc., 2020 WL 1547383, at *1 (S.D. N.Y. 2020) (holding that while "Gram" token purchase agreements were not securities by themselves, Telegram's pre-sale scheme, including the Gram purchase agreements and related understandings and undertakings, were securities).

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