CRYPTOCURRENCY
Coinbase v. Securities and Exchange Commission
Date: March 27, 2024
Issue: Whether Coinbase violates securities laws by intermediating transactions involving securities.
Case Summary: A Manhattan federal court denied Coinbase’s motion for judgment on the pleadings in the Securities and Exchange Commission’s (SEC) lawsuit alleging it operated as an unregistered securities exchange, broker and clearing agent.
The SEC alleged Coinbase offered and sold crypto assets without registering those offers and sales as securities. Coinbase is the largest crypto-asset trading platform in the United States, serving over 108 million customers. Among the services Coinbase provides are Prime, Wallet and Staking. The Prime service allows institutional customers to execute secondary-market transactions at scale. The Wallet service enables retail and institutional customers to store and access crypto assets on their computers and mobile devices. The Staking program allows customers to transfer crypto assets in exchange for rewards.
On June 6, 2023, the SEC sued Coinbase alleging it violated the Securities Exchange Act of 1934 by operating as a national securities exchange, broker, and clearing agency without first registering with the SEC. The SEC also claimed Coinbase violated the Securities Act of 1933 by engaging in the unregistered offer and sale of securities with its Staking program. Thirteen crypto assets offered on Coinbase’s platform were at issue. However, Coinbase argued none of the transactions the SEC identified qualified as an investment contract and thus were not securities. On Aug. 4, 2023, Coinbase moved for judgment on the pleadings. Judge Katherine Polk of the Southern District of New York denied Coinbase’s motion.
First, the court rejected Coinbase’s procedural claims alleging the Major Questions Doctrine, Due Process Clause, and Administrative Procedure Act (APA) precluded the SEC from alleging the crypto assets were investment contracts. The Major Questions Doctrine requires any agency action seeking to decide an issue of major national significance to be supported by clear congressional authorization. The court considered the crypto industry “sizable and important,” but noted it falls short of bearing vast economic and political significance. Next, the court determined the SEC did not violate the Due Process Clause because the SEC provided “fair notice” that crypto assets traded on the Coinbase Platform and through Prime would be treated as securities. Finally, the court concluded the SEC did not violate the Administrative Procedure Act because the SEC was not promulgating new rules or a new regulatory policy.
Second, the court concluded the SEC plausibly alleged at least some crypto asset transactions on Coinbase’s platform and through Prime are investment contracts. To determine whether the transactions constituted investment contracts, the court relied on SEC v. Howey. Under the Howey test, an investment contract exists “when a person: (i) invests his money, (ii) in a common enterprise, and (iii) is led to expect profits solely from the efforts of the promoter or a third party.” Coinbase did not dispute the purchasers of the crypto assets invested money. As a result, the court examined the remaining two prongs of the Howey test.
On the common enterprise prong, the court concluded the crypto asset purchasers were in a common enterprise with the developers of those assets. The SEC alleged there was a common enterprise through horizontal commonality, which involves pooling assets from multiple investors to share profits and risks of the enterprise. According to the SEC, token issuers, developers and promoters represented how proceeds from crypto asset sales would be pooled to develop the tokens’ ecosystems. What is more, they promised purchasers that improvements would benefit all token holders by increasing the value of the tokens themselves. The court found that the SEC sufficiently alleged investors reaped profits from the increased value of their tokens. Accordingly, the transactions satisfied the second prong of the Howey Test.
On the expectation of profits prong, the court concluded purchasers of the crypto assets had a reasonable expectation of profits from the efforts of others. The SEC claimed the issuers and promoters of crypto assets repeatedly encouraged investors through websites, social media posts, investor materials, town halls, and other forums to buy tokens by advertising how their technical and entrepreneurial efforts would be used to improve the token’s value. Coinbase conceded these statements reached not only the purchasers in the initial coin offering, but also potential investors considering whether to acquire crypto assets in the secondary market. The court reasoned that an objective investor in the primary and secondary markets would perceive these statements as promising the possibility of profits derived from others’ efforts. Having satisfied all three prongs of the Howey test, the court concluded the transactions were investment contracts and therefore, securities.
Third, after determining Coinbase facilitated transactions in crypto-asset “securities,” the court declined to dismiss the SEC’s claims alleging Coinbase operated as an exchange, securities broker, and clearing agency. The court reasoned Coinbase brings together purchasers and sellers of securities and executes their orders, thus making the company an exchange. The court determined Coinbase “engaged in the business of effecting transactions in securities for the account of others” which qualified the company as a broker. Finally, the court concluded Coinbase “acts as a custodian of securities” and thus qualifies as a clearing agency.
Fourth, the court found that the SEC plausibly alleged Coinbase engaged in the unregistered offer and sale of securities through its Staking program. Under the Staking program, customers’ assets are transferred to and pooled by Coinbase and subsequently staked by Coinbase in exchange for rewards, which Coinbase distributes pro rata. Coinbase claimed the Staking participants do not invest money under Howey because the program creates no risk of loss. In response, the SEC alleged Coinbase never effected a registration statement, and this failure deprives investors of material information about its offerings in connection with the Staking program.
In reaching its decision, the court found that the SEC adequately alleged the Staking Program constitutes an investment contract under Howey due to: the risk of loss associated with participation in the Staking program; Coinbase’s significant technical efforts in implementing and maintaining the program; and Coinbase’s promotional efforts to drive customer participation in the program. The court also found that the SEC’s complaint adequately alleged an investment of money and Staking participants reasonably expected to profit based on Coinbase’s managerial efforts. Accordingly, the court concluded no exemption for registration applied.
However, the court dismissed the SEC’s claim alleging Coinbase acted as an unregistered broker through its Wallet service. The court determined the SEC’s claim failed to establish how Coinbase acts as a “broker” by making Wallet available to customers.
Bottom Line: A pre-trial conference is scheduled for Oct. 24, 2024.
Documents: Opinion
