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SEC Coinbase Suit

posted by Adam Levitin

The SEC has finally brought its long-anticipated lawsuit against Coinbase. The suit alleges that Coinbase has operated as an unregistered securities broker, an unregistered securities exchange, and an unregistered securities clearing agency, and that it has made unregistered sales of securities, namely of its staking-as-a-service products. The litigation hinges entirely on one key question: are any of several tokens listed or products offered by Coinbase “securities.” If the tokens and products are not securities, then Coinbase has no problem. And if they are securities, Coinbase almost assuredly loses.

I’m not going to get into the token-by-token is-it-a-security analysis in this post other than to note that the SEC need only prevail on one token or the staking-as-a-service product in order to win. The business ramifications for Coinbase do, however, depend on how many tokens or products are deemed securities. If it’s a single token, Coinbase can cease offering it, pay a civil monetary penalty, disgorge profits, and move on. If it’s a product like staking-as-a-service, Coinbase can potentially alter the terms of the product and try again or cease offering the product, which will make it a bit less competitive, but hardly a death blow. But if it’s the gamut, then it’s going to cast real doubt on Coinbase’s analysis of the securities status of everything its listing and on Coinbase’s ability to operate in its current form, which combines brokerage, exchange, and clearing functions. (And to be clear, that combo does not violate securities laws…if there is no security involved.)

We haven't yet seen Coinbase's legal response, but Coinbase’s CEO, Brian Armstrong, has responded publicly with a bunch of claims, most of which have no legal relevance:

1. "The SEC reviewed our business and allowed us to become a public company in 2021." This is a claim with zero legal relevance. The SEC reviewed Coinbase’s registration statement for its 2021 IPO, but that’s a review to ensure compliance with IPO regulations, which are basically about disclosing material risk factors. (Among the risks disclosed by Coinbase was the risk that it could be deemed a securities broker, so this is hardly an ambush.) The SEC’s review of the IPO documents isn’t a review for compliance with other securities laws, any more than the DMV issuing you title to a car is not a driver’s license or an emissions test.

2. "There is no path to "come in and register" - we tried, repeatedly - so we don't list securities. We reject the vast majority of assets we review." This is what the litigation is about. Are the tokens and products offered by Coinbase securities? The fact that it’s difficult if not impossible to register sales of tokens isn’t a defense to failing to register, and Coinbase’s internal review process is at best a defense toward civil monetary penalties based on willfulness/recklessness (but might also risk waiving attorney-client privilege).

3. "The SEC and CFTC have made conflicting statements, and don't even agree on what is a security and what is a commodity." This is true, but once against legally irrelevant. It’s not the CFTC’s lane to determine what is a security, and the CFTC has never expressed an opinion about the particular tokens and products at issue in this suit. Fortunately, we have courts to sort out this sort of thing.

4. "This is why the US congress is introducing new legislation to fix the situation, and the rest of the world is moving to put clear rules in place to support this technology." Maybe a legislative deus ex machina rescues Coinbase, but I wouldn’t count on it. Voyager, Celsius, and FTX really took the wind out of crypto's sails, and the transformative innovation pitch gets less and less credible every day that it isn't actually delivered.

5. "Instead of publishing a clear rule book, the SEC has taken a regulation by enforcement approach that is harming America." I think the SEC’s response would be something like “the rules are clear:  you cannot have an unregistered interstate sale of securities to the public.” Coinbase doesn’t like that rule, of course, or at least doesn’t like it if any of the tokens and products it offers are securities. But there’s a world of difference between “I don’t like the rule” and “the rule isn’t clear.” Now Coinbase can rightly say that it isn’t clear whether any particular token is a security or not. But that’s true for lots of investment products, and all the more so when there is motivated thinking about the application of the Howey test. Whether to assume the risk that a product is a security is a business decision, and if you are going to accept the profits, you need to be prepared for the losses.

Another name for “regulation by enforcement” is “enforcement of existing regulations”. The SEC isn’t pushing a novel legal theory in the Coinbase action. It’s pretty garden variety. The only novel question is whether certain tokens and products offered by Coinbase are securities. The SEC, applying a well-established test, says so. Coinbase presumably disputes it, as is its right, but that’s a dispute about an application of a well-established legal principle to some new facts, which is something that happens all the time, as most cases are not exactly like previous ones. 

Armstrong's argument is also naive and/or disingenuous about the nature of regulation vs. litigation. Suppose the SEC proposed a set of cryptocurrency regulations today. Would it result in any certainty? Not any time soon. It would probably take 2+ years for the regulation to be finalized and then there would be another 2+ years of litigation challenging them and possibly sending the SEC back to the drawing board, meaning probably 5 or more years of the crypto industry being allowed to operate without regulation. In contrast, we're likely to see a resolution to this litigation well before then, and that resolution is likely to provide a good deal of clarity about the application of securities laws to crypto. Regulated businesses reasonably complain about enforcement actions as not providing clear guidance or an iterative feedback process for all (indirectly) affected parties, but rulemaking has become so difficult and slow because of legal challenges that agencies are strongly incentivized to act through the enforcement process.

Armstrong's arguments generally have nothing to do with the legal issues in the case. Instead, he's trying to fight the case in the media, and the communications battle is lopsided—the SEC will have little if any comment about the case publicly, while Coinbase and the entire crypto industry will keep up their narrative. This is the same thing we’ve seen with Ripple. That's not to say anything about particular claims, only that it's good to keep the lopsided nature of the media battle in mind when evaluating the situation and to realize that the media battle is not what determines courtroom outcomes.


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