Two cases pitting an aggressive SEC against the largest U.S. cryptocurrency exchange could clarify the legal status of digital assets —or finally force the politicians to do so.
By Maria Gracia Santillana Linares and Steven Ehrlich, Forbes Staff
The Securities and Exchange Commission’s suit against Binance may be spicier, but it’s a pair of court battles between the SEC and Coinbase that could determine the future of cryptocurrency trading in the U.S. And significantly, Coinbase, the nation’s largest crypto exchange, is playing offense as well as defense.
Decisions in these cases could end (or hasten the end of) a standoff between an industry determined to disrupt traditional finance, but rife with malfeasance, and regulators who have thus far attempted to rein in the crypto business through ad hoc enforcement, rather than deliberate rulemaking.
“We’re prepared to rely upon the courts because we think it’s critical to the future of our industry,” Coinbase Chief Legal Officer Paul Grewal tells Forbes. “The one thing we can’t do is continue to operate in this world of uncertainty,” he adds, with “arbitrary and capricious enforcement action as the sole means by which crypto in the U.S is regulated.”
Since CEO Brian Armstrong cofounded Coinbase in 2012, it has fashioned itself as the safe, blue chip exchange, the one that would play by the rules—or at least to the extent the law made that possible, while also staying competitive. It cleared SEC scrutiny of its financial disclosures to become the only publicly traded U.S. crypto exchange via a direct Nasdaq listing in April 2021. Its financials are audited by Deloitte & Touche.
But Coinbase’s relationship with the SEC has deteriorated as the company has become more impatient and adventurous in its offerings and the agency has dragged its feet on regulations, while becoming more crypto-skeptical. That came into sharper public view in July 2022 when Coinbase filed a petition requesting that the SEC start spelling out a regulatory framework for cryptocurrencies, including a definition of what would make one a security, subject to the SEC’s rules. The petition rightly pointed out that other jurisdictions, including the European Union, Australia and the United Kingdom, were pushing ahead with regulations designed to meet the needs of the crypto market while protecting investors.
The SEC’s response? It simply didn’t respond.
Then, this past March 22, the SEC warned Coinbase (in what’s known as a Wells Notice) that it was likely to soon be the target of an enforcement action. “We asked the SEC for reasonable crypto rules for Americans,” Grewal complained in a company blog post disclosing the SEC notice. “We got legal threats instead.”
Coinbase rushed to the courthouse first. In April, it asked the Third Circuit Court of Appeals to force the SEC to at least respond to its by then nine-month old petition, even if only to deny it, which would open the door to a lawsuit against the agency. “We were never set on court, but we were always preparing for court,” Grewal says.
Coinbase’s suit was “a tactical and proactive way” for the exchange to position itself before the SEC had a chance to sue it, observes Rebecca Fike, a partner in the Dallas office of Vinson & Elkins and a former senior counsel at the SEC’s enforcement division.
Sure enough, on June 6 (a day after it sued Binance) the SEC filed its threatened enforcement action against Coinbase. The complaint alleged Coinbase violated securities laws by failing to register as an exchange when (according to the SEC’s analysis) at least 13 of the 200 plus cryptocurrencies it lists are securities and also by offering “staking” services which should themselves have been registered as investments with the SEC.
In contrast to its suit against Binance, the SEC made no claims that Coinbase engaged in manipulative trading or flouted anti-money laundering rules and offered no smoking (or at least headline-grabbing) internal messages. (“We are operating as a fking unlicensed securities exchange in the USA bro,’’ Binance’s chief compliance officer had messaged a colleague, according to the SEC’s suit.) And whereas the SEC sued Binance founder and CEO Changpeng Zhao (known as CZ) along with his company, Coinbase’s Armstrong was not named as a defendant by the SEC. Instead, the agency chided Coinbase for publicly marketing itself “as a ‘compliant’ actor in the crypto asset space,” while placing its interests in profits “over investors’ interests, and over compliance with the law.”
“We’re proud to represent the industry in court to finally get some clarity around crypto rules,” Armstrong Tweeted in a defiant response that accused the SEC of taking a “regulation by enforcement approach that is harming America.’’
Two days later, the Third Circuit gave Coinbase some small satisfaction, ordering the SEC to at least say when it would respond to Coinbase’s rulemaking request–although the reply could still be a denial. The SEC had argued in May that Coinbase was not entitled to compel it to act on the petition and that it was still considering the matter, which made its silence “entirely reasonable.” But after the Third Circuit issued its order, the SEC grudgingly asked for 120 more days for the SEC staff to make a recommendation to the commissioners on Coinbase’s petition. This week, the Third Circuit gave the SEC until Oct. 11 to report back to the court.
It’s crucial to point out here that in urging the SEC to act on its petition, Coinbase certainly isn’t conceding that the SEC has authority to regulate all crypto trading–just the opposite. In a friend of the court brief Coinbase filed this past year in the SEC’s suit against a former Coinbase manager and his brother, its lawyers explicitly argued that absent further action from Congress, the SEC does not have the legal authority to regulate the tokens traded on its exchange as securities. (And if those traded tokens aren’t securities, then Coinbase didn’t need to register as a securities exchange.) But Coinbase was obviously hoping to hash out this issue during rulemaking or a court challenge to SEC rules–not in an enforcement action against it.
Now, between the two Coinbase cases, the Binance suit and an older SEC suit against payments processor Ripple, courts are—appropriately or not— being asked to do something Congress and the regulators have so far failed to do: clarify how crypto fits (or in the case of Congress, should fit) into American securities law.
Results of the court cases could shed light on two key questions. First, what determines if a cryptocurrency is a security? Second, how can exchanges and other digital-asset intermediaries legally register to do business in the U.S.? If the answers are unworkable or inconsistent from court to court, pressure could increase on Congress to write new laws that fit the industry better. “If you’re not gonna get it from congressional action, you’re gonna get it from the courts,” says Hailey Lennon, a partner in the Digital Commerce group of Brown Rudnick, a former regulatory counsel at Coinbase and a Forbes contributor.
Digital assets might appear, on their face, to be a new type of investment that doesn’t fit neatly into the current regulatory categories of securities, commodities or actual currencies. But SEC Chairman Gary Gensler, appointed by President Joe Biden, seems to have little doubt that many digital offerings are securities: “The vast majority of crypto tokens meet the investment contract test. Not liking the message isn’t the same thing as not receiving it,” he declared at the Piper Sandler Global Exchange & Fintech Conference earlier this month.
The agency determines if a financial instrument is a security using the Howey test, which is based on a Supreme Court ruling in a 1946 case of that name involving, of all things, Florida citrus groves. If something is an agreement on a common enterprise, with the expectation of profit to be derived from the efforts of others, then it qualifies as an investment contract under Howey. Sell that contract to an investor and it is a security under the SEC’s oversight and subject to the Securities Act of 1933 and the Securities Exchange Act of 1934.
“That they’re digital doesn’t differentiate them from huge swaths of the capital markets, where securities and currencies already are digital,” Gensler said of crypto tokens.
Still, there is no court ruling, regulation or law that explicitly names which tokens are securities or defines the specific characteristics of tokens that would make them securities—only claims in civil suits brought by the SEC and experts’ differing opinions on how Howey might apply to crypto. Moreover, there seems to be no way for crypto exchanges to register with the agency, if for no other reason than at least some of the assets they are trading are now considered by the SEC to be unregistered securities, a no-no for a registered exchange.
“There seems to be a Catch-22,” says Lennon. “If an exchange were listing unregistered securities there also doesn’t seem to be a path forward to become a registered platform with the SEC.” Echoes Vinson & Elkins’ Fike: “It is a challenging space, even if you are genuinely trying to comply with the SEC, to know exactly how to do that.”
But just as it’s easy to see Coinbase’s dilemma, it’s also easy to appreciate what is animating regulators like Gensler. Crypto has proven to be a dangerous place for investors, especially small ones, with hacks, bogus coin offerings and outright theft plaguing the sector. Last year brought a record for crypto hacks, according to blockchain analytics firm Chainalysis, with $3.8 billion worth of assets stolen. Over $20 billion of cryptocurrency was received by illicit addresses, added the firm. That accounted for 0.24% of all cryptocurrency transactions, double the share of the 2021.
Then there’s the not-so-small matter of the sudden bankruptcy last November of crypto exchange FTX, amid allegations that founder Sam Bankman-Fried and his cohorts fraudulently used customer deposits to subsidize their own crypto trading losses and their lifestyles. (He has pleaded not-guilty, but key associates have pleaded guilty.) After FTX’s spectacular collapse, the tone of Coinbase’s conversations with the SEC changed, according to Grewal. “It fundamentally ground to a halt whatever productive dialogue we were having in a way that led to talks eventually breaking off,” he says. As Coinbase waited for the SEC to respond to its ideas and proposals on regulation, the SEC effectively ended conversations and issued a Wells Notice to the company.
It also doesn’t help the crypto industry’s case that Coinbase and its competitors have typically merged the trading function of a financial exchange with brokerage, clearing and settlement—services that are carried out by separate intermediaries in traditional finance. “Crypto intermediaries may need to separate lines of business, put into place rulebooks that protect against fraud and manipulation, properly segregate customer funds, mitigate conflicts, or change their approach to clearing and custody,” Gensler said at the Piper Sandler conference. “The fact that they didn’t build their platforms with these things in mind shouldn’t be a free pass to put investors at risk.”
Indeed, the SEC’s suit alleges Coinbase made billions of dollars by “unlawfully facilitating the buying and selling of crypto asset securities” by intertwining the “traditional services of an exchange, broker, and clearing agency” without registering with the government to provide those functions. As a result, the suit alleges, the company “deprived investors of significant protections.”
Coinbase’s Grewal, takes issue with the SEC’s “unlawfully” characterization. After the company went public in 2021, Coinbase continued to converse with the agency regarding digital asset rules and “continued to believe the SEC was operating in good faith,” says Grewal. He no longer believes that, he says.
The regulators do seem to have hardened their stance. Back in 2018, for example, Gensler (then an MIT professor and a former Commodity Futures Trading Commission chairman under President Barack Obama) told students and hedge-fund managers that bitcoin, ether, litecoin and bitcoin cash were not securities. That same year, William Hinman, then director of the SEC’s corporate finance division, said he did not think ether was a security. But in April of this year, Gensler refused at a House hearing to address his current view of ether’s status.
The politicians haven’t been ignoring digital assets—they’ve had hearings and plenty of bills have been introduced. But they haven’t agreed on what to do about them. Over 50 crypto-related bills were introduced in the House and Senate in 2022. This month, House Financial Services Committee Chair Patrick McHenry (R-N.C.) and House Agriculture Committee Chairman Glenn Thompson (R-Pa.), floated a discussion draft of a bill that would allow digital assets that are initially considered securities, subject to SEC oversight, to eventually be regulated as commodities by the Commodity Futures Trading Commission. It would also create a new sort of registered digital exchange.
On the same day the SEC filed its suit against Coinbase, Grewal testified in favor of that draft to the House Agriculture committee. The bill “would be a new path created by Congress to enable companies to offer side-by-side trading of digital commodities and digital securities,” he said, adding that the bill addresses points in Coinbase’s rulemaking petition to the SEC.
The bill is unlikely to pass the Senate, says Austin Campbell, adjunct professor at Columbia Business School and former chief risk officer at stablecoin issuer Paxos, especially since a divided Congress “doesn’t know” what a unified approach to regulation would look like. In fact, he’s skeptical any meaningful change will pass during the current Congress, with Republicans controlling the House and Democrats the Senate.
What could break the political stalemate? An election. Or maybe the litigation. The lawsuits against Coinbase and Binance could “provoke legislative action regardless of if the exchanges prevail,” securities lawyer Michael Blankenship, managing partner of Winston & Strawn’s Houston office and his associate Jacob Botros, predicted in a joint email to Forbes.
Meanwhile, Coinbase plans to operate its business as usual, without abandoning listings or investment products the SEC has targeted as unregistered securities. “If we need to make structural adjustments to our business to accommodate legislation and allow us to offer digital assets securities for the first time in the United States, we’re prepared to do that,” says Grewal.
In March, before the SEC warned that an enforcement action was probable, Coinbase’s stock was trading around $85, down from $342 in its first day as a public company in April of 2021. By the time the SEC actually filed suit on June 6th, investors had mostly priced in the probability of an enforcement action, says John Todaro, a senior analyst at Needham. After the suit was filed, the shares took a modest hit, but are now trading around $58—where they were on June 5th. At these prices, Todaro rates Coinbase a buy.
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