No surprises here: SEC claims against Coinbase to proceed

Last week, U.S. District Judge Katherine Polk Failla for the Southern District of New York denied Coinbase’s attempt to have its case against the Securities and Exchange Commission (SEC) dismissed.

Judge Failla ruled that the SEC had “sufficiently pleaded” that Coinbase operated as an exchange, broker, and clearing agency, and engaged in the unregistered sale of securities through its staking program. However, Failla did dismiss the SEC’s claim that Coinbase acted as an unregistered broker when it made its wallet application available to customers.

The SEC sued Coinbase on June 6, 2023, accusing the exchange of violating securities law. Coinbase rejected the regulator’s accusations and, in August 2023, filed a motion to have the case dismissed—known as a Motion for Judgement on the Pleadings—arguing that no securities violation had taken place and that the action was a jurisdictional overreach on behalf of the SEC.

However, Coinbase failed to convince Judge Failla that the SEC’s case against it had no merit, and now the case will proceed to trial—likely not until 2025. The SEC and Coinbase must submit a proposed case management plan before April 19.

Coinbase’s Chief Legal Officer Paul Grewal sought to play down the company’s failed dismissal bid.

“Today, the Court decided that our SEC case will move forward on most of the claims, but dismissed the claims against Coinbase Wallet,” said Grewal, posting on X (formerly Twitter). “We were prepared for this, and we look forward to uncovering more about the SEC’s internal views and discussions on crypto regulation.”

In relation to the claims against Coinbase Wallet, the exchange’s self-custody digital asset wallet app, Judge Failla determined the SEC failed to allege that Coinbase conducted brokerage activity through the app.

Howey and legal precedents

One of the core arguments Coinbase attempted to use to have the SEC’s case against it dismissed was the idea that the assets in question did not amount to “investment contracts” and were, therefore, not securities.

Whether a digital asset is a security in the U.S. relies on the Howey Test, which derives from a 1946 U.S. Supreme Court case—SEC v. W.J. Howey Co.—relating to whether a Florida citrus grove investment scheme constituted a security.

According to the Howey Test, an asset is a security if:

1. It is an investment of money;
2. In a common enterprise;
3. With an expectation of profits;
4. Solely from the efforts of others.

If an asset meets these four criteria, it can be seen as an “investment contract,” a form of asset written into securities law.

The court in Howey also made a point of saying that its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

This is the legal precedent that SEC Chair Gary Gensler and his colleagues are using to classify digital assets and have been for some time.

In July 2023, Judge Torres threw a cat amongst the pigeons when she ruled on two summary judgment motions—requests for rulings on specific aspects of a case submitted before the final judgment—in the SEC’s case against Ripple Labs, declaring that institutional sales of XRP amounted to illegal securities based on the Howey test, but that “programmatic sales” of XRP through exchanges and algorithms (secondary sales) did not, due to the lack of “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”

The SEC is suing Ripple, along with its CEO Brad Garlinghouse and Executive Chairman Christian Larsen, for engaging in illegal securities offerings from 2013 to the present, based on the sale of digital assets XRP.

Judge Torres’ rulings seemed to add some fuel to the arguments of those, such as Coinbase, who are attempting to claim that many digital asset sales/transactions don’t meet the ‘expectation of profits from the efforts of other‘ criteria of the Howey Test.

However, this fleeting victory was short-lived. On December 28, 2023, Judge Jed Rakoff—presiding over the SEC’s case against Terraform Labs—granted the regulator’s summary judgment, declaring that Terraform and its CEO, Do Kwon, sold unregistered securities—including LUNA and the UST algorithmic stablecoin—to the public before Terraform’s
untimely implosion in May 2022.

Terraform Labs had attempted to use the Ripple decision to have its own SEC case dismissed, but Rakoff rejected the court’s approach in the Ripple case as inconsistent with the Howey Test and suggested that secondary sales can amount to illegal securities transactions.

This week’s ruling in the Coinbase case sees the courts again backing the SEC’s application of Howey, painting the Ripple ruling as the outlier and the Terraform and Coinbase results as the dominant interpretation.

Long-predicted result

Judge Failla’s will come as no surprise to those who’ve been paying attention to the prevailing winds of U.S. regulation over the past few years.

The SEC and its Chairman Gary Gensler have consistently stuck to the line that Bitcoin is the only digital asset out there that is not a security, based on its application of the Howey Test.

This begs the question: How did Coinbase think it could slip a number of digital assets that are not Bitcoin past the SEC without them deeming them unregistered securities?

The exchange should have known from the outset that its business model would come into conflict with the SEC’s take on digital assets, yet it ploughed ahead with listing the various assets that the SEC is lately pointing out are securities. A point that was not lost on the regulator.

In a July 7 filing, the SEC suggested that Coinbase was “ignoring more than 75 years of controlling law under Howey” in its insistence that it engages in asset sales, not securities transactions, and that, in fact, the exchange “understood that the securities law could apply to its conduct … but nevertheless made the calculated decision to take on this risk in the name of growing its business.”

At the risk of reveling in an overdue, ‘I told you so,’ this publication has long been attempting to warn the likes of Coinbase—and anyone else that continues to make the case that digital assets are not securities—that they are on to a losing argument.

Judge Failla’s ruling against Coinbase, which appears unlikely to be overturned on appeal, only provides further evidence that those developing and transacting digital assets in the U.S. must wake up and smell the roses. Rather than continuing to scream into the void that digital assets are not securities, they should be focusing their attention on getting themselves compliant with SEC rules and obligations.

After all—despite how some in the industry may present it—the SEC is not attempting to ban digital assets. It is simply against unregistered securities and those who deal in them. So, perhaps the more pressing question is: Why are asset issuers and the businesses who deal in those assets so reluctant to register?

Unfortunately, one suspects the answer probably has more to do with reluctance about opening up books and practices to regulators than it does with any genuine belief in an alternate interpretation of the assets.

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