Coinbase, which is by trade volume the largest cryptocurrency exchange in the United States, announced yesterday it had been hit by the Securities and Exchange Commission (SEC) with a threat of looming legal action.
As a public Form 8-K filed by Coinbase with the SEC explained, "On March 22, 2023, Coinbase…received a 'Wells Notice' from the Staff…of the Securities and Exchange Commission….stating that the Staff has advised the Company that it made a 'preliminary determination' to recommend that the SEC file an enforcement action against the Company alleging violations of the federal securities laws."
In that 8-K filing, which is required to inform the public about important events that might affect shareholders, Coinbase explained that, based on what SEC staff have communicated to them, "these potential enforcement actions would relate to aspects of the Company's spot market, staking service Coinbase Earn, Coinbase Prime and Coinbase Wallet. The potential civil action may seek injunctive relief, disgorgement, and civil penalties." (The news is indeed affecting stockholders, with Coinbase's stock down roughly 13 percent today as of this article's publication.)
Coinbase Chief Legal Officer Paul Grewal went public with a lot of the frustration that has hit market participants in crypto (and even federal bankruptcy judges) as they try to navigate the SEC's approach to virtual currencies. Grewal explained how the SEC under chair Gary Gensler has been reshaping regulatory law and policy via enforcement (and the occasional vague public threat).
Grewal echoed the complaints many have had while trying to understand exactly why and when the SEC believes that a cryptocurrency is a security and able to be regulated as such, and thus that companies facilitating trading in them face certain registration requirements. "We asked the SEC specifically to identify which assets on our platforms they believe may be securities, and they declined to do so," Grewal wrote.
"We continue to think rulemaking and legislation are better tools for defining the law for our industry than enforcement actions," Grewal went on to say. He again echoed a long-term frustration with the SEC's apparent desire to reveal what it believes the law requires not through rigorous understandable written notice—something more like actual law or rule making—but by just bashing certain crypto market players against the wall, seemingly at random.
Grewal defended Coinbase's efforts in trying to understand the law and follow it. In the course of the investigation that led to this week's notice, "the SEC asked us if we would be interested in discussing a potential resolution that would include registering some portion of our business with the SEC. We said absolutely yes. Specifically, the SEC asked us to provide our views on what a registration path for Coinbase could look like – because there is no existing way for a crypto exchange to register."
Grewal said that after trying to get the SEC to give feedback on various registration models that Coinbase proposed, the agency generally stonewalled, was unresponsive, and eventually in January just "told us they would be shifting back to an enforcement investigation." Coinbase insisted "our staking and exchange services are largely unchanged since 2021, when the SEC reviewed our S-1 and allowed us to become a public company," he wrote. "Our core business model remains the same."
Grewal noted that different federal agencies have given conflicting reports on the way to legally categorize certain virtual currencies: "The Chair of the CFTC [Commodity Futures Trading Commission] recently testified to Congress that Ethereum is a commodity, which the public has long understood to be the case. Then-CFTC Commissioner Quintenz has said that 'the SEC has no authority over pure commodities or their trading venues, whether those commodities are wheat, gold, oil…or crypto assets.' Current SEC Chair recently opined that perhaps BTC [bitcoin] is the only digital asset commodity, which is entirely at odds with the position of the CFTC."
"If our regulators cannot agree on who regulates which aspects of crypto, the industry has no fair notice on how to proceed," Grewal concluded. "Against this backdrop, it makes no sense to threaten enforcement actions against trusted public companies like Coinbase who are committed to playing by the rules."
Whether or not a financial instrument, agreement, or coin in the virtual currency space constitutes a "security" under the reigning "Howey test," based on the 1946 Supreme Court case SEC v. W.J. Howey Co, continues to be a matter that courts seem to have to sort out on a case-by-case basis. While complex, as most legal definitional principles are, a central element of Howey is that the buyer and seller of the product are involved in a common enterprise involving a monetary investment in which reasonable expectation of profit is derived from the effort of others. Most argue that most virtual currencies are more like commodities whose values fluctuate based on mass market demand, not based on any effort of the original issuer. As Coin Center Director of Research Peter Van Valkenburgh explained in an interesting article assessing whether ether (the second-highest-market-cap virtual currency) should be legally categorized as a security, there is a meaningful distinction between a virtual object that may at some time have been part of some arrangement or offer that might be reasonably seen as a security and a virtual object that is in and of itself always a security.
Grewal insisted that nothing on his exchange should qualify as a security, including the staking services that he said the SEC has been familiar with since 2019. "Until this investigation, we had heard no concerns at all from the SEC about" them, he explained.
Grewal believes, as do many in the crypto space who have been watching with dismay as the SEC's wrecking ball swings unpredictably, that SEC actions like this "will only drive innovation, jobs, and the entire industry overseas."
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