Author: Duane Morris

A New York federal court has held that the SEC sufficiently pleaded that Coinbase—a well-known cryptocurrency exchange, broker, and clearing agency—operated as an unregistered intermediary of securities and engaged in the unregistered offer and sale of securities through its crypto staking program.  In a partial win for Coinbase (and possibly others offering wallet services), the court dismissed the SEC’s claim that Coinbase acted as an unregistered broker by offering a crypto wallet application to its customers.  The case is Sec. and Exch. Comm’n v. Coinbase, Inc., 23 Civ. 4738 (S.D.N.Y. Mar. 27, 2024).

This decision has important ramifications for all players in the crypto market, as it clears the way for the SEC to continue to act as the primary regulator of crypto in the absence of further regulatory direction from Congress and allows the SEC to continue aggressive enforcement in the crypto space.

Coinbase operates as one of the world’s largest crypto trading platforms that offers additional services that complement its crypto trading operations.  Coinbase “Prime” is a service that institutional customers can use to execute large volumes of crypto trades through both Coinbase and third-party trading platforms.  Coinbase “Wallet” is a self-custodial wallet that allows customers to store crypto assets on their own computers or mobile devices with the ability to connect to decentralized exchanges to trade these assets.  Coinbase’s staking program allows customers to earn financial rewards (usually in the form of cryptocurrency) for transferring custody of assets to Coinbase, who in turn takes a commission from the staking profits and returns the balance to the customer.

On June 6, 2023, the SEC brought a lawsuit against Coinbase under the Securities Act of 1933 and the Securities Exchange Act of 1934.  The SEC alleged that Coinbase violated the law by acting as an unregistered securities broker, an unregistered securities exchange, and an unregistered securities clearing agency.  The SEC named a dozen popular crypto assets (including Solana and Chiliz) and argued that these assets met the legal definition of a “security” (in SEC parlance, an “investment contract”).  Thus, the SEC alleged that Coinbase violated the law by working with these assets and not registering with the SEC.  Coinbase moved to dismiss the SEC’s complaint, contending primarily that none of the crypto assets named by the SEC met the definition of an investment contract and Coinbase therefore was not subject to federal securities laws.

The decision, authored by Judge Katherine Polk Failla in the Southern District of New York, first held that the SEC was not violating regulatory and administrative law by instituting its enforcement action against Coinbase.  The court then applied the well-known Howey test for investment contracts and held that the SEC plausibly alleged that at least some of the crypto asset transactions on Coinbase’s platform (including those on its Prime service) constituted investment contracts.  After finding that the SEC plausibly alleged that Coinbase facilitated transactions in securities, the Court declined to dismiss the majority of the SEC’s claims alleging that Coinbase violated the federal securities laws. Additionally, the Court held that the SEC adequately alleged that Coinbase’s crypto staking program was an investment contract subject to federal securities law.

Notably, the court rejected Coinbase’s argument that secondary market transactions–those that involve an asset purchaser buying crypto assets from someone other than the original issuer–were excluded from the definition of investment contracts.  Coinbase relied, among other cases, on the July 2023 decision in SEC v. Ripple by another judge in the Southern District of New York, which held that Ripple’s sales of XRP (a crypto token) on secondary platforms did not constitute securities transactions (SEC v. Ripple also held that sales of XRP to institutional investors did constitute securities transactions).

Without directly contradicting the Ripple decision, Judge Failla ruled that crypto transactions on the secondary market cannot be categorically excluded from constituting investment contracts.  The Howey test makes no such distinction and Judge Failla found little logic to the attempt to draw a distinction between investors who buy directly from the issuer and those who purchase on the secondary market in reliance on “promises and offers made by issuers to the investing public.”  In her opinion, Judge Failla cited favorably to the December 2023 decision SEC v. Terraform Labs, from yet another judge of the Southern District of New York, which rejected many of the same arguments Coinbase raised regarding transactions on the secondary market.

The court did, however, dismiss the SEC’s claim that Coinbase conducted unregistered securities brokerage activity through its “Wallet” application.  The court noted that the Wallet application did not undertake routing activities traditionally carried out by securities brokers, including directing how and when to execute trades.  Indeed, the SEC’s allegations conceded that Coinbase had no control over a user’s crypto assets via the “Wallet” application.  This was ultimately fatal to the SEC’s claim because the SEC failed to adequately allege that Coinbase was acting as a broker.

The Coinbase decision provides the SEC with a win in two areas.  First, the court held that the SEC’s aggressive crypto enforcement actions did not violate federal or regulatory law, paving the way for the SEC to continue acting as the primary U.S. crypto regulator.  Second, the decision held as a matter of law that the SEC adequately alleged that Coinbase’s crypto services dealt in investment contracts.  Finally, the balance of cases within the Southern District of New York has now tipped decidedly in favor of the conclusion that, when the elements of the Howey test are met, there is little distinction to be drawn between investors who buy directly from the issuer and those who purchase on the secondary market.  While the SEC may not necessarily prevail at trial, this opens the door for further crypto enforcement actions and provides a strong basis for such actions to proceed past the pleading stage into the expensive and time-consuming process of discovery and motion practice.