If you follow financial and crypto news, there are good chances you're aware of the ongoing dispute between the SEC and Coinbase. The years-long saga is not just a complex legal battle. In taking its fight into the related fields of public relations, lobbying, and politics, Coinbase seeks to eschew the tethers of securities regulation by playing multi-dimensional chess.
Introduction
On the litigation front, the conflict turned hot in June last year when the SEC brought civil charges against Coinbase through a complaint filed in the United States District Court for the Southern District of New York. The SEC charged Coinbase with its crypto asset trading platform as an unregistered national securities exchange, broker, and clearing agency.
The below text briefly provides an update on the status of Securities Exchange Commission vs. Coinbase, Inc. and Coinbase Global, Inc., and a summary of the parties' core arguments. The case has not progressed quickly, but pending developments are likely to soon grasp the attention of many observers within the financial, crypto, and legal communities.
Status of the Case
Pursuant to an early motion for judgment on the pleadings filed by Coinbase, the District Court put the ordinary course of proceedings on pause. The Court set a briefing schedule to allow the parties and interested non-parties to file legal briefs supporting or opposing the motion. Briefing on the motion is now closed. Several non-parties have filed "amicus curiae" briefs.
The Court will hear arguments on the motion for judgment on January 17, 2024, beginning at 10. a.m. EST. Given the great public interest in the dispute, the Court has made available a public "listen-only" line. To observe the arguments in real time, members of the public can dial in to the hearing by calling (888) 363-4749 and entering access code 5123533 at 10 a.m. on the 17th.
If you plan on listening in on the whole thing, be prepared. Each side will have four hours of oral argument to make their case. You may wish to stash a trove of your favorite coffee or energy drink nearby.
The SEC's Charges against Coinbase
The core of the SEC's claims rest on the notion that certain tokens traded on Coinbase constitute "securities" under U.S. securities law.1 Securities can lawfully be made available for trading by the public only on a registered exchange and only registered brokers can perform brokerage services in connection with securities trading. Coinbase is not authorized to act as a securities exchange by way of registration or through any exception, nor is Coinbase registered as a broker of securities.
On that basis, the SEC asserts that Coinbase is operating both as an unregistered securities exchange and as an unregistered broker (with respect to any tokens that are securities). Coinbase allegedly acted as an unregistered exchange "by providing a market place that, among other things, brings together orders of multiple buyers and sellers of crypto assets and matches and executes those orders[.]" It allegedly acted as a broker by "soliciting potential investors, handling customer funds and assets, and charging transaction-based fees." Additionally, Coinbase is accused of acting as an unregistered clearing agency (custody and trade settlement services for securities requires registration with the SEC) by "holding its customers' assets in Coinbase-controlled wallets and settling its customers' transactions by debiting and crediting the relevant accounts."
In a previous blog, found here, I explained how certain regulatory regimes—including the mandatory registration of exchanges and brokers in connection with securities trading—could potentially apply to Coinbase and other crypto exchanges. The SEC's complaint also contains descriptions of those regulations and requirements.
Coinbase's Defense
In Coinbase's answer and its legal briefing supporting the motion for judgment on the pleadings, the crypto powerhouse centers its case around the heart of its argument: the SEC lacks authority to regulate Coinbase. This bold position is principally grounded on two contentions.
First, Coinbase maintains that none of the digital assets traded on the Coinbase platform are securities. Second, Coinbase argues that the SEC's actions against its trading platform violates the so-called "major questions doctrine," which is grounded on the separations of powers and prevents executive agencies from adopting new regulatory schemes or programs, reserving to Congress the power to create new laws.
Are the Tokens Securities? The Howey Test:
Whether the "digital assets" at issue are determined to be securities will depend on whether the presiding judge believes they are "investment contracts" under the Howey test.2 In the Howey case (and in cases following Howey), the Supreme Court found that an "investment contract" exists when there is (1) an investment of money in (2) a common enterprise with (3) a reasonable expectation of profits (4) to be derived from the efforts of others.3
Coinbase's initial brief and reply brief supporting the motion for judgment on the pleadings, make a compelling case that digital assets traded on its platform are not securities. The arguments challenge whether token sales can qualify as "investment contracts" under all elements of the Howey test. But boiled down, the core proposition is that the digital assets traded on the platform are "a company's products," the "output of the business," and a "commodity." According to Coinbase, because tokens sold on its platform are not the subject of any formal contract entitling their holders to payment from the issuers or to any interest in their assets, the tokens cannot qualify as "securities" as a matter of law. As stated in its brief, when tokens are purchased through Coinbase, "there is no investment of money coupled with a promise of future delivery of anything. There is an asset sale. That's it. It is akin to the sale of a parcel of land, the value of which may fluctuate after the sale. Or a condo in a new development. Or an American Girl Doll, or a Beanie Baby, or a baseball card." In its view, to qualify as an "investment contract" under securities law, a digital asset must involve a "contract."
The valiant arguments offered by Coinbase are confronted with the SEC's proven track record of success in litigation involving crypto tokens, including on the issue of defining tokens as securities. The SEC's analytical position is laid out clearly in its Framework for "Investment Contract" Analysis of Digital Assets (the "Framework"). In its complaint, the SEC clearly alleges facts supporting its contention that several tokens tradable on Coinbase are securities consistent with its Framework (which is based on the Howey test). In a prior blog (found here) discussing a related case, I summarized the SEC's application of facts relevant to certain of the digital tokens to each element of the test.
The SEC's response to Coinbase's motion highlights decisions from within the Southern District of New York in which courts found that a formal financial interest or common law contract is not required to establish an investment contract. It argues that no profit sharing or payment right from the issuer of the security is necessary to create such an expectation, which can come from the representations of issuers and promoters. Under this view, a purchaser of a digital asset would only need to believe that her investment would increase in value through the managerial efforts of a token issuer to create the necessary profit expectation. In this regard, the SEC highlights that the relevant token issuers touted—via whitepapers and other statements, including on the platform—their bona fides and future efforts to "build ecosystems" that drive demand for tokens, generating an expectation of profits.
In that respect, the SEC argues that the sale of crypto assets on Coinbase is nothing like the sale of collectible items like baseball cards or other tangible assets. It states that "the token (which is just software) has no innate or inherent value of its own—it is tied to its underlying value, which for the crypto assets at issue in this case, is the investment contract. Without the access to a service or the intellectual property those crypto assets signify, they would be worthless. After all, investors are not purchasing those assets to own a digital sequence of letters and numbers." For the SEC, the bottom line is that the value of the digital asset is based on the underlying value created, built, and maintained by the blockchain network's management.
Coinbase's First Tactic: Motion for Judgment on the Pleadings
By filing judgment on the pleadings under Federal rule of Civil Procedure 12(c), Coinbase has asked the District Court to determine that, even if the factual allegations of the SEC are true, it cannot be liable because the tokens its sells are definitively not securities or because the SEC otherwise lacks congressionally granted authority to regulate digital assets. Rule 12(c) motions are a vehicle "to dispose of cases where the material facts are not in dispute and a judgment on the merits can be rendered by looking to the substance of the pleadings and any judicially noticed facts."4 A court's review of such motions is limited to the pleadings, meaning outside evidence is excluded. For that reason, in most well-pleaded cases where questions of facts are disputed by each side, motions for judgment on the pleadings do not have a high likelihood of success. But here, because the SEC appears to have conceded that the tokens in question do not involve formal contracts between issuers and holders, Coinbase may prevail if the Court is persuaded that token issuers must have continued formal contractual obligations to a holder for their tokens to qualify as an investment contract.
Conclusion
The dispute between the SEC and Coinbase involves high stakes and, one way or another, it will have a dramatic impact upon Coinbase and the digital assets industry. This is reflected in the caliber of each side's legal representation, as demonstrated by the briefing offered by both sides. Due to the potential fallout in the industry from an SEC victory, some industry participants (including Coinbase) express befuddlement about how or why the SEC allowed Coinbase stock to be registered if Coinbase conducted business in violation of U.S. securities law. But putting aside potential fairness issues involving the investing public, these complaints arguably reflect misconceptions concerning the regulation of U.S. securities offerings, which primarily applies a disclosure-based regulatory model, rather than one in which regulators review offerings for their merit.5 And, in fact, the SEC forced Coinbase to disclose in its registration statement the regulatory risks that materialized in the present lawsuit.
Ultimately, both sides present plausible arguments rooted in judicial precedent and the relevant statutes. The position of Coinbase is arguably supported by statutory language defining as a security an "investment contract" and the fact that relevant appellate cases have concerned financial interests that entitled their holders to some sort of contractual right to payment from the issuer. Also, as Coinbase argues, a limiting principle may be necessary to cabin the SEC's authority; without one, the SEC could arguably regulate the seller of any conceivable asset if the seller promised future conduct to increase the value of that asset and thereby led buyers to expect profit on an eventual resale. On the other hand, the SEC's position seems more consistent with the federal courts' historical interpretation of the Securities Act and the Securities Exchange Act. Courts have focused on the public-protection mission of securities law. Where a transaction arguably creates a security, courts have evaluated "economic realities," looking past the form of the transaction to its substance. They have often noted that the term "securities" is defined broadly to apply to any future ingenious "scheme" or "transaction" designed to avoid securities regulation. Moreover, recent history may be seen as demonstrating that SEC regulation is justified because the investing public is at significant risk of harm in connection with investments in certain digital assets.
Considering the plasticity of the term "security" under U.S. securities law and its purpose of protecting investors, the District Court may simply decide the case on a principle of common sense: "if it quacks like a duck, it's a duck." With respect to investing and trading, the crypto world "looks" and behaves much more like a traditional securities market than a baseball card exchange. Unless Coinbase scores an unlikely homerun with its pending motion for judgment on the pleadings, its struggle with SEC will likely continue into extra innings.
Footnotes
1. The SEC also alleges that Coinbase itself has unlawfully sold unregistered securities through its staking program. The complaint asserts that the "staking-as-a-service program" offered by Coinbase constitutes a security sold to public without a prerequisite registration. This post omits discussion of this and other issues.
2. See our blog published here for a discussion of the Howey case.
3. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) ("Howey"). See also United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975); Tcherepnin v. Knight, 389 U.S. 332 (1967); SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344 (1943).
4. Great Plains Trust Co. v. Morgan Stanley Dean Witter & Co., 313 F.3d 305, 312 (5th Cir. 2002) (citation omitted).
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