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Coinbase and the SEC

posted by Adam Levitin

"All fintech is regulatory arbitrage, to some degree," Felix Salmon writes at Axios. And he's right. In the last couple of days we've seen two striking examples. First, the CFPB entered into a consent order with the provider of Income Share Agreements, a type of education financing. The consent order makes clear that the CFPB will be treating ISAs as student loans--that is credit--and therefore subject to the Truth in Lending Act and Equal Credit Opportunity Act.

And then we saw crypto-Twitter blow up over Coinbase's spat with the SEC regarding what is a security. Coinbase is the largest crypto exchange in the United States. It wants to offer a cryptocurrency lending product called Lend. According to Coinbase, the SEC told Coinbase that it thinks the product is a security and that it will sue if Coinbase offers the product without first registering it. After Coinbase got a Wells Notice from the SEC, Coinbase got huffy and decided to take its case to Twitter with a thread by it's CEO calling the SEC's behavior "sketchy".

There's a lot of confusion about the Coinbase matter, so I'm going to spell out what the stakes are, how I think the product works, and then why (assuming that I have the product's operation correct) Lend is obviously a security.

Why It Matters If Lend Is a Security

If Lend is a security, then certain laws kick in, including laws prohibiting fraud or manipulation in the purchase or sale of a security. More immediately, though, if Lend is a security, then Coinbase may not offer Lend to the public without registering it with the SEC.

Securities registration is a disclosure process that ensures that the market has adequate information to price efficiently, which has important implications about the efficient allocation of capital in society and financial stability. Registration is also the hook for a bunch of other regulatory requirements. The registration process has nothing to do with the underlying merit of the security.  It's just about disclosure. You can sell junk bonds or even shares of an empty box to the public as long as you have registered the shares with the SEC. The disclosure process is backed up by liability for material misstatements and omissions in a registration statement. (There are a bunch of exemptions from the registration process, but they only come into play if there is a security in the first instance and are not at issue here.)

Let me underscore, that nothing about the registration process is a judgment about the merits of Lend or of cryptocurrency or DeFi, etc. These are just the rules of the game that everyone who sells securities to the public has to follow, and those rules are in place because of long experience with investor losses and negative social externalities when there haven't been the disclosures required by the registration process.

Let me also underscore, that the SEC isn't telling Coinbase that it cannot offer a cryptocurrency lending product. It's just saying that if Coinbase wants to offer the product it has to first register the product. Registration has some costs, but I suspect the real reason for the resistance is that registration pulls Lend into the SEC's regulatory orbit, and going back to Felix Salmon's point, Coinbase might prefer to live outside the reach of the SEC. (Ironically, while Coinbase's users are all fired up on Twitter, they would only benefit from registration--it won't cost them anything, unless they're hoping to engage in market manipulation.)

How Lend Works

My understanding of the proposed Lend product comes from Coinbase website. The details here matter, and the technical legal documentation isn't public, but I am assuming that Coinbase is accurately describing its own product. Here's the situation: suppose you're a consumer who wants to buy some cryptocurrencies. You go to a crypto broker-dealer like Coinbase and buy some crypto. But because crypto is all digital, you need a "wallet" where you can keep it. Coinbase provides that service as well. It's not just the broker-dealer, but also the custodian. Now remember that when you deposit funds with someone (an "ordinary deposit"), you have made them a loan:  there's a debtor-creditor relationship. In contrast, if you put money into a safe deposit box, that's a "specific deposit", and is not a loan, but a bailment, where you have a right to get the specific asset back, and the bailee has no right to use it (see this old Abraham Lincoln case where the bailee rides the horse put in bailment--a 19th c. Ferris Buehler parking valet).

Normally, Coinbase is taking funds as a "specific deposit". It doesn't hold legal title to the crypto funds and isn't allowed to use the crypto funds it holds on specific deposit. It just acts like a giant safe deposit box or coat check. What Coinbase is proposing with its Lend product is that it put those deposited funds to work, making them an ordinary deposit instead of a specific deposit. So if a consumer opts into Lend, Coinbase would be allowed to relend the the deposited funds. Right now Coinbase is proposing doing this solely with a type of stablecoin called USD Coin. (USDC is itself basically an unregistered money market mutual fund, but that's another story, even though Lend appears designed to boost demand for USDC. Coinbase's apparent past misrepresentations about USDC, namely the claim that it is fully backed by cash, rather than by a mix of assets, might be a factor in all of this too.)

Coinbase doesn't provide a lot of details about how the lending would work, but presumably Coinbase is looking to make money, so Coinbase will relend out the USDC to various end-borrowers at, say 6% APY. Coinbase's depositors who agree to participate are only promised a return of 4% APY, which appears to be based solely on the performance of the loans made by Coinbase, but Coinbase guaranties the principal on the loan.

Again, Coinbase doesn't provide a lot of details, but I do not think it is merely providing a peer-to-peer matching, such that the funds are loaned directly from the consumer to the end-borrower. Instead, it appears that the funds are loaned from the consumers to Coinbase, and then separately from Coinbase to the end-borrower. Accordingly, I think the product likely functions with two levels of pooling of funds. First, I am assuming that Coinbase will pool depositors' funds. That is, if I have $100 and you have $100 and Gary Gensler has $100, our money might be pooled together to make a $300 loan to Elon Musk. Without such pooling, Coinbase would have trouble matching lenders and end-borrowers.

Second, I am assuming that Coinbase will pool the returns on the loans it makes. So, let's imagine that Coinbase loans $300 to Musk, $400 to Mark Cuban, and $500 to Brian Brooks. Your money might have gone to fund the loan to Musk, but your return will not depend solely on the performance of the Musk loan. Instead, the return that Coinbase will offer will depend on the blended return it gets from Musk, Cuban, and Brooks. Therefore, even if Musk defaults, you get some protection from the diversified portfolio with Cuban and Brooks. Coinbase doesn't state this explicitly, but I think this is implicit in Coinbase advertising a 4% APY to everyone. If the return depended on the individual loan, they couldn't advertise a one-size-fits-all return.

[Update: It turns out that even though Lend isn't currently being offered, its terms are included in Appendix 6 to Coinbase's general User Agreement.  The information there confirms my assumptions about how Coinbase works. A few choice lines from the User Agreement follow with my commentary in italics:

You understand and agree that by electing to participate in Lend (i) your eligible Digital Currency will no longer be custodied with Coinbase and Coinbase will have no legal obligation to custody your Digital Currency pursuant to its licensure as a money transmitter; (ii) Coinbase has the authority to use your Loaned Digital Currency in any manner it chooses; and (iii) Coinbase is under no obligation whatsoever to disclose how it uses your Loaned Digital Currency. Your Lend APY does not vary based on what we do with your Loaned Digital Currency.

This confirms that the profits or losses on Lend depend solely on Coinbase's skill and expertise in investing the loaned crytpo. And Coinbase doesn't have to say how it's investing it. It could be betting on race horses or chasing penny stocks or making leveraged bets on cryptocurrencies, and they don't have to tell you.

By participating in Lend, you are making a loan of your eligible Digital Currency to Coinbase, Coinbase is your counterparty and you will have only a contract claim against Coinbase for the return of Loaned Digital Currency. As with any loan transaction, you could lose all your Loaned Digital Currency if we are unable to repay your loan.

Again, this is confirming that this is not a defi P2P product, but just a good old fashion deposit with Coinbase for Coinbase to invest.

Coinbase may use Loaned Digital Currency in its sole discretion, including uses which generate returns for Coinbase in excess of the Lend APY, which Coinbase is entitled to as compensation for Lend. Any returns generated by the use of Loaned Digital Currency are not returned to you as part of Lend interest. Therefore, although the interest rate will be determined in accordance with Section 2, the interest rate is determined by Coinbase and Coinbase may have a conflict of interest with you in setting the Interest Rate.

This confirms what I suggested above, namely that Coinbase might invest in assets yielding 6% APY, but only give the borrower 4% APY. I particularly love the statement that Coinbase might have a conflict of interest in setting the interest rate on Lend. ]

Is Lend a Security?

So this brings us to the legal question of what is this creature? Is it a security or not?

The definitions of "security" in the 33 Act and the 34 Act are long lists that are not especially informative, but there are a lot of court decisions that explicate the terms. There are three Supreme Court decisions that immediately leap to mind as informative. One is the 1946 Howey decision. Howey dealt solely with the question of what is an "investment contract," which is one of the many things in the definitional list of "security." The test announced by Howey is a test for whether something is an investment contract and therefore a security. It is not a generic test of whether something is a security, as there are things besides investment contracts that are securities.

The Howey test requires a "transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party".  So four elements: (1) investment of money, (2) a common enterprise, (3) expectation of profits, and (4) profits solely from the efforts of the promoter or a third party. Applying them:

Investment of Money. This element is clearly met, especially as case law has made clear that it does not have to be US dollars.

Common enterprise.  Most courts require "horizontal commonality," namely the pooling of money from multiple assets and pooling of profit/loss allocations. If there is the pooling that I think must exist with Lend, then this element would seem to be met. If Lend is somehow just a P2P brokering platform, then there shouldn't be horizontal commonality. But nothing suggests that Lend is P2p. Instead, it appears to be a pooling of consumers' USDC to fund loans, and then an allocation of the aggregate profits from those loans to consumers.

Some courts look for "vertical commonality," meaning that the investor's profits or losses depend on the efforts of the promoter of the transaction, irrespective of whether other investors exist. That also seems to be met here. A consumer's return on Lend depends on (1) Coinbase's skill and expertise in lending out the USDC (and that's true even if the lending is basically automated, as Coinbase had to write/approve the automation) and (2) Coinbase's guaranty of principal. (Some courts require that the promoter profit only if the investor profits, what's called "narrow vertical commonality". That too seems met given the guaranty.)

Expectation of profits.  Well duh.

Profits solely from the efforts of the promoter or a third party. That's basically the vertical commonality point discussed above. If Coinbase makes bad lending decisions, the consumer won't get the 4% APY that's promised.

Another possibility is that Lend is a "note," rather than an investment contract. The test for whether something is a "note" and hence a security is the Reves familial resemblance test. That's one of those Sesame Street, which of these things is more like the other, tests. If the purported "note" is similar to something that's known to be a security, then it will be treated as a security, and if it's not similar, than it won't be.  When undertaking this analysis and deciding whether to announce new exceptions to the "not securities" list, courts consider the motivations of the buyer (earning profits) and the seller (raising funds), whether the instrument is distributed for investment, whether the investing public would reasonably expect the application of the securities laws to the instrument, and whether there is an alternative regulatory regime governing the instrument.

Applying Reves, Lend might also be a note. It's an instrument that promises a return of principal plus a fixed amount of interest. That sure looks like the basic structure most notes. Looking more closely, however, the best analogy would be a deposit. Indeed, Coinbase itself compares the product to savings accounts. That's a problem for Coinbase because there is no applicable alternative regulatory regime. Indeed, in another case, Marine Bank v. Weaver, the Supreme Court held that a bank certificate of deposit was not a security primarily because of the existence of the alternative regulatory regime of the FDIC. The implication of Weaver is that an uninsured CD is as security.

I'm not sure that "investment contract" and a "note" are mutually exclusive categories, but even if they are, the particular box we might place Lend doesn't really matter as it just needs to be a security one way or the other. Now others might disagree with some of my application, and the application is dependent on the facts of the product--there might be details that change things, but I want to emphasize that I have trouble seeing how any crypto-specific details—smart contracts, etc.—would affect the analysis.

Coinbase hasn't really spelled out its legal argument for why it's not a security, but it seems to suggest that Howey and Reves are not appropriate tests for cryptolending products without saying why. Howey has been applied to all manner of things--orange groves, chinchillas, minks, so what is so different about Coinbase or other crypto other than that (like everyone else) they don't want to be a security?

I'll also note, that there's a possible argument that by offering Lend, Coinbase would be an unregistered investment fund. But that's not the issue right now.

Where Things Stand Procedurally

Coinbase was serve a Wells Notice by the SEC. When we say "SEC," we're actually conflating two separate things: the Commissioners themselves, who have the complete decisionmaking power at the agency, and the staff, who undertake investigations and prosecutions, subject to the direction of the Commissioners. A Wells Notice is a courtesy notice that the SEC staff intends to recommend that the Commission bring charges. Charges themselves cannot be brought without the approval of the Commissioners themselves. The Wells Notice is a sort of last chance notice that lets the company know what the staff has concluded, but the company still has a chance to argue its position before the Commission via a public Wells Submission. I believe there's usually a two week window for a Wells Submission. (Maybe one could view Coinbase's CEO's tweets as a sort of Wells Submission?) Usually the Commission will follow the staff’s recommendations about instituting litigation, but not always.

What About the Other Guys?

One of Coinbase's gripes is that the SEC is giving it a hard time, but hasn't gone after competitors that have offered similar products without registering. I don't think this is a legitimate complaint. Coinbase has been the crypto company that has been the most willing to engage with the financial regulatory system: it is publicly traded, so its own securities are registered with the SEC. Its competitors are regulatory wildcats. But that shouldn't have led Coinbase to think that it would get a free pass from the SEC. The answer to inequality can be level up, as well as level down.

Additionally, this could just be a timing issue. The Trump SEC wasn't going to touch this stuff. So we have a new page with the Biden SEC. Because Coinbase engaged with the SEC, the SEC had the information necessary to make a judgment about the product. With Coinbase's competitors, the SEC would have to first commence an investigation. That takes time and won't be public initially. So it might simply be too soon for Coinbase to complain about disparate enforcement. Additionally, the SEC might conclude that instead of running down lots of firms through the litigation process that it would do better with a rulemaking. Again, that doesn't happen overnight.

In any case, this complaint about disparate enforcement is hardly an answer to whether Lend is a security. "What about the other guys," isn't ever a great defense.

Comments

The case you cite is Reves, not Reeves. You keep doing this, so I assume it's intentional.

Eileen--thanks and corrected. Unintentional. I blame it on too much Chaucer (the Reeve's tale, etc.)

A company does not register securities. It registers the offer and sale of securities.

Willard, you're technically correct of course, but surely you also know that the colloquial shorthand is to refer to the registration of securities and (un)registered securities.

I don't think you should use securities law colloquialisms when doing securities law analysis. It makes me think you lack the requisite expertise.

I'm writing on a _blog_. This isn't a SCOTUS brief. I'm going to use colloquialisms, including the ones that securities lawyers themselves regularly use.

Here's an example from an American Bar Association publication: https://www.americanbar.org/groups/business_law/publications/blt/2017/04/06_loev/

In the first sentence, the ABA does refer to the registration of the offering or sale, but later it says "In order to register a security under the Securities Act, a company must file a registration statement with the SEC."

The analysis itself speaks to whether I have the requisite expertise, and if you think I'm wrong on any of the substance of the analysis, you're welcome to comment here, but please don't be such a nudnik.

Wow, the comments (not counting responses from Prof. Levitin of course) here so far have been truly obnoxious, pedantic, and unproductive. Let me just try to buck that trend by saying that I really enjoyed the post and the analysis seems accurate (although I'm no particular securities expert).

BTW, I was directed here by the Business Law Prof blog.

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I enjoyed the post & although I'm no securities expert, I must say the analysis seems accurate to me also (despite the "nudniks" presence).

First, I agree completely with kotodama. Second, I make no claim to be a securities attorney. That said, I am puzzled by the Following: 1) Why aren't cryptocurrencies being treated as securities outright. Because they are securities. They certainly aren't money, regardless what their promoters claim. 2) Why aren't these "wallets" being treated as self-directed brokerage accounts? Because that's what they are, and Coinbase should therefore be treated as a brokerage whether it wants to be or not. 3) You are absolutely correct that Lend is a security, and I think it goes beyond what you've noted. Through Lend, Coinbase is converting these accounts into stakes in an investment pool that is effectively blind, beyond the "disclosure" that the money will be loaned to as yet undetermined parties on as yet undetermined terms for a promised return to the account owner of X%.

Great analysis as always. These two FDIC opinions on insurance coverage for enhanced yield certificates of deposit support the notion that an uninsured CD is a security.
FDIC-85-25: Enhanced Yield Certificates of Deposits: https://www.fdic.gov/regulations/laws/rules/4000-1880.html#fdic400085-25
FDIC-86-29: Insurance Coverage for Enhanced Yield Certificates of Deposit: https://www.fdic.gov/regulations/laws/rules/4000-2200.html#fdic400086-29

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