Coinbase v. SEC: Will the COIN Shorts Win?
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2023 has been an onslaught of regulatory attacks on crypto. With the industry being financially weakened from the collapses of major funds and exchanges, there have been few companies willing and able to put up a strong defense, let alone a counterattack.
One company stands out from the pack - Coinbase.
Today we cover Coinbase’s response to the SEC Wells Notice, the potential implications for the crypto industry and what it means for Coinbase (we have a contrarian view).
The case is unique and raises some novel issues which have not been litigated in the crypto context. Spoiler: the much discussed Howey test might not even be relevant.
After our deep dive on a few of the more interesting legal questions, we’ll present our views on what this could mean for the industry and share a trade idea.
Let’s dive in.
The Role of the SEC
If you’ve been paying attention to crypto regulation you’ll know that the SEC keeps harping on “unregistered securities”. The mantra is that the sale of unregistered securities is bad (and illegal!) because investors risk their capital without a fair disclosure of how the business will be operated and the risks involved.
But what about “registered securities”?
When a company decides to go public, the SEC plays a crucial role in reviewing the offering to protect investors. One of the primary ways the SEC oversees this process is through the filing and review of a registration statement (Form S-1). Here’s how it works.
First, teams of bankers, lawyers, and other professional advisors charge the Company a small fortune to create a draft registration statement which meets all the disclosure requirements. This lengthy document covers every facet of the business from operations to financial condition and the planned use of funds raised in the offering. It also includes an investor prospectus which has key facts the law says investors need to know to make an informed decision.
Then the SEC assigns a team of reviewers to scrutinize the document for compliance. These staffers are also trained lawyers, accountants, and financial analysts. If the SEC’s advisors identify issues, they will issue comment letters (we’ll see why this is important with Coinbase later) which the Company must respond to by providing the required information in an updated draft S-1 filing.
When the SEC is satisfied that all concerns have been adequately addressed, it declares the registration statement “effective”. This means the company has met its regulatory requirements and can offer its securities to the public.
The SEC’s rhetoric against crypto emphasizes that “unregistered securities” - a term applied to almost all coins except Bitcoin - bypass this process, preventing the SEC from keeping investors safe.
Sidebar: Wells Notice. This is a formal notification from the SEC that it is considering enforcement proceedings. It follows an investigation by the SEC focused on potential violations of securities laws. On receiving a Wells Notice, the Company can submit a written statement to persuade the SEC not to take enforcement action. This statement can include explanations, mitigating factors and legal defenses. Coinbase has issued its statement and the next step is for the SEC to decide whether to proceed with any enforcement action.
Protect Me Harder?
The amusing irony in any clash between Coinbase and the SEC is of course that the SEC itself scrutinized Coinbase’s business in detail during the registration process, declared it kosher, and allowed Coinbase to go public. Coinbase sold its shares to millions of investors. This is a core part of Coinbase’s argument.
Then, as now, the core business of Coinbase was operating a crypto exchange which allowed members of the public to buy and sell cryptoassets. The regulator now says in its enforcement proceedings that Coinbase isn’t allowed to operate such an exchange, and that the cryptoassets it lists are unregistered securities.
And a typical outcome of enforcement proceedings (Wells Notice) is that the Company agrees to stop doing whatever the SEC is complaining about. For Coinbase that would mean shutting down key business units like staking forever (like Kraken recently agreed in order to settle with the SEC) and making huge changes to its core trading business. This impacts directly on shareholder value.
If Coinbase doesn’t roll over to these demands (it probably can’t) then it’s forced to exhaust all other avenues through protracted and expensive litigation which will probably impact the stock price in the short term, hurting some investors.
To recap:
the SEC tells us the registration process exists to ensure that investors have complete and truthful information about a company before they invest
crypto tokens are bad because they don’t disclose this information, meaning that investors face unknown risks
the SEC gave the green light to Coinbase IPO, implying to the public that the SEC thought the business was legal and investors had all the required information to evaluate the risks
then the SEC says Coinbase’s core business is illegal and offers the choice between a settlement which destroys shareholder value or an expensive legal dispute which will impact the price of the stock due to uncertainty
It’s difficult to imagine a more ironic scenario which makes the regulator appear totally incompetent. But. There’s nuance to this so let’s now refresh on the key events.
Timeline
Prior to 2020: Coinbase acquires money transmitter licenses in all relevant states (2014), a BitLicense from the State of New York (2017), a SEC-noticed Alternative Trading System company (2018), and an SEC-registered broker-dealer company (2019). The ATS and broker-dealer are still dormant, pending regulatory approval.
October 2020: Coinbase submits first draft S-1 to SEC
December 2020: Coinbase submits its legal analysis of its staking services
February 2021: SEC sends second comment letter, Coinbase respond with their legal analysis on whether coins listed on its spot exchange are securities
April 2021: SEC declare Coinbase’s S-1 effective; Coinbase shares list under the ticker COIN; million of investors participate in the offering
May 2021: SEC Chair Gensler testified before Congress that there is no federal authority to bring a regulatory regime to crypto exchanges, the SEC lacks authority to regular businesses like Coinbase, and that Congress would need to legislate further on crypto
November 2021: Coinbase met with Chair Gensler to discuss registering a securities trading platform
July 2022: Coinbase files formal petition for rulemaking, including 140 specific questions for the SEC
Q4 2022: Coinbase meets with SEC staff (including Enforcement) to discuss paths to registration and related matters 12 times, a total of 30 meetings in 9 months
November 2022: FTX collapses
December 2022: SEC Chair Gensler states that the SEC has the authority to require crypto exchanges to register as National Securities Exchanges (NSEs) - but Congress has not expanded the powers of the SEC since Gensler’s testimony in May 2021
January 2023: Enforcement Staff informed Coinbase they would be
proceeding with enforcement and no longer engaging on registrationFebruary 2023: Kraken settles with SEC; pays $30mm, agrees to permanently withdraw staking
March 2023: Coinbase receives a Wells Notice
April 2023: Coinbase sues SEC to compel a response to the July 2022 rulemaking petition. A response from the SEC is required in the next 10 days
In summary: Coinbase has a long history of seeking compliance, good engagement with the regulator, and its various business lines were clearly disclosed in its registration statement. Enforcement action only occurred after the FTX collapse.
Sidebar: Kraken’s settlement. Founder Jesse Powell wrote on Twitter that settlement was the best “risk-adjusted return…for our company. I do think a different company, with different corporate structure, shorter operating history, some product/marketing/ToS differences might make a different decision. Bigger balance sheet wouldn’t hurt either. [the SEC] picked the bottom of the bear market, waited for us to do a 30% layoff. They have all our financials, lots of leverage. Maybe we looked weak. This is more about FTX than it is us or staking but the timing was not great. Potential fines obscene. | Source
Key Legal Points
Coinbase has taken aim at three legal theories that regulators have been beating the industry over the head with
all coins are securities and all exchanges need to register
offering staking services is illegal (Kraken)
software applications are brokers
Let’s examine these in detail.
Coinbase Argues The Howey Test Doesn’t Apply
Coinbase argues it does not deal in securities, as the term is defined by the Securities and Exchange Acts, and digital assets are not inherently securities.
The legal status of digital assets depends on whether they are "investment contracts" under the Howey test.
However, digital assets themselves, like the orange groves in Howey, aren't securities; only when they're part of an ongoing investment contract or scheme do securities laws apply.
Lawyers for Sullivan & Cromwell must have endured some late nights looking up case law relating to securities to find authority for the proposition that the investment contract, not the subject of the investment contract, is caught by securities laws. Case summaries include: sales of “live breeding beavers” plus service agreements for their care was an investment contract, without suggesting that the beavers themselves were securities! And so it is with PEPE tokens?
The SEC must prove, case-by-case, that specific digital assets traded on Coinbase are part of ongoing investment contracts. Coinbase argues they aren’t, for these reasons:
There is no investment contract between Coinbase users who buy/sell computer coins and the issuer of those assets. No token issuer can raise capital from users trading on Coinbase.
Prior cases applying Howey to cryptoassets targeted the issuers, who raised capital by selling the unregistered securities - not exchanges or activities in the secondary market. Secondary market trades fail all four prongs of the Howey Test:
Investment of Money: In secondary market transactions, the investment doesn't go to the issuer or promoter, but to the previous owner of the digital asset.
Common Enterprise: There is no common enterprise when users buy tokens on Coinbase.
Expectation of Profits: For digital assets with consumptive utility or stablecoins, the expectation of profit prong is not met. Securities laws don't apply when the motivation is consumption or use. DeFi Ed: as an example, LINK tokens which are used as payment for oracle services.
Efforts of Others: Secondary market transactions lack "efforts of others," particularly when the promoter's initial protocol development is complete. Established digital assets have different dynamics, with few managerial efforts involved or even no managers at all. In some cases the original issuer or its management may have gone bust and no longer promote the token but the token can still be traded.
Courts have held that when an asset's value is determined by pre-existing secondary markets rather than a promoter or issuer's efforts, the efforts of others prong is not satisfied. Many cryptoassets traded on other secondary markets for years before being listed on Coinbase.
If you’ve been keeping up with regulatory developments in crypto you’ve probably read enough about Howey and orange groves. So far as it applies to DeFi DEXes being potentially held liable as “unregistered securities exchanges” we hope Coinbase’s arguments prevail. It will be interesting to see whether the SEC takes on the challenge of proving its arguments in court.
Let’s now turn to the other important crypto product lines that the SEC has targeted, and the legal arguments raised by Coinbase in response.
Staking Rewards Are Payment For Services, Not Investments
Native Ethereum staking remains technically complex for the average user. And it’s a coordination nightmare for whales who must run 1 validator for every 32 ETH they wish to stake. In the DeFi world we have Lido and Rocket Pool who simply provide a server hosting arrangement for a fee. Just like Amazon Web Services or Google Cloud.
Should this be illegal? We think not. But what we think doesn’t matter. If regulators (and Courts) deem it illegal, the operators of these services face risks and Americans may be excluded from earning a staking yield. The dispute between Coinbase and the SEC has wide ranging implications for crypto’s “risk-free yield”.
Coinbase argues:
it only provides IT services: servers, internet, electricity with a similar bundled pricing model to other ‘cloud’ services
it doesn’t make any investment decisions
staking isn’t an investment contract under Howey, failing all four prongs
there is no “investment of money” - users are exposed to the same risks as if staking natively (without a service provider): users retain title to their assets, which are ring fenced from claims by Coinbase’s creditors, and assets can be unstaked at any time (subject to underlying protocol rules)
in Proof of Stake blockchains, stakers operate validators which provide computing services to protocol users - the staking yield is therefore a fee for providing services not a “return on investment”
the “efforts of others” test isn’t met because there is no managerial or entrepreneurial efforts made by Coinbase: they just provide servers to run the protocol staking software and coordinate user deposits/withdrawals. This doesn’t impact on the potential return to users.
These appear to be forceful arguments. As the term “yield” is used for staking pools, we often think of it as a pure investment and ignore the fact that the validator (backed by the staked tokens) performs a service on a computer network. It’s not a passive investment, we just have smart tech which abstracts the actual work away from the user who is staking the assets.
If the SEC back off, or a Court rules favorably, we have clarity for the legality of DeFi staking services.
Wallets Are Software Tools, Not Brokers
Coinbase argues it’s wallet software is not a broker as it does not meet the legal definition of a broker under the Exchange Act.
Wallets are software tools that enables users to interact with secondary markets, and the transactions involved do not constitute securities.
Coinbase Wallet also fails to meet the factors considered by courts when determining broker status:
involvement in negotiations
providing investment advice
actively finding investors.
Crypto wallet software is asset-agnostic, was not built for securities transactions, and does not handle customer funds, securities, or order routing. Users maintain custody of their assets and decide when and where to trade them without any direction from Coinbase.
Wallet does nothing more than make available passive software that provides users a digital asset self-custody solution through which they may engage in activities of their choosing without direction or recommendation by Coinbase—this is wholly insufficient to characterize Wallet as a broker under applicable law
Summary
Coinbase’s lawyers at Sullivan and Cromwell appear to have done an excellent job attacking the legal basis under which the SEC purports to have jurisdiction over trading of crypto tokens in secondary markets, offering staking services, and writing wallet software. If these arguments succeed, either with the SEC enforcement team or before the courts, there’s a strong possibility that we see a sudden rethink of the government’s approach to regulating these aspects of the crypto economy.
And that’s long overdue.