Court Permits Coinbase Enforcement Action to Proceed, Highlighting Need for Clarity

Recently, Judge Failla of the Southern District of New York joined a growing number of federal courts that have taken a broad and flexible view of whether transactions involving crypto-assets such as Solana (SOL) can constitute an “investment contract,” and in turn, a security under the federal securities laws.  If not reversed, this decision, as well as other recent decisions employing a broad “holistic” approach, will make it extremely difficult for the “crypto” industry to know with clarity whether any transactions involving digital assets fall outside the scope of the federal securities laws.[1]  In addition, the SEC seems content to forgo rulemaking in favor of continued enforcement actions.  Therefore, barring congressional action to clarify this issue, many in the industry will likely struggle to avoid SEC enforcement.

In SEC v. Coinbase, Inc. et al.,[2] the SEC alleged that Coinbase engaged in transactions with respect to 13 crypto-assets and those assets constituted “securities” with respect to the alleged transactions.  Therefore, the SEC alleged that Coinbase violated federal securities laws by acting as an unregistered exchange, offering unregistered securities, and acting as an unregistered broker.  The Court permitted the majority of the SEC’s claims to go forward, finding that the SEC adequately pled that at least two crypto-assets offered on Coinbase’s platform – SOL and Chiliz – constituted investment contracts under the Howey test,[3] and therefore securities, but handed a victory to Coinbase in dismissing the SEC’s claim that Coinbase acted as an unregistered broker via its “Wallet” application.

The Court’s analysis started with the Supreme Court’s seminal decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which created a three-prong test to determine whether a transaction constitutes an “investment contract,” and therefore, a security.  The test asks whether the transaction is: (i) an investment of money, (ii) in a common enterprise, (iii) with profits to be derived solely from the efforts of others.

Drawing on prior opinions within the Second Circuit, particularly Judge Rakoff’s Terraform Labs decision,[4] the Court adopted the view that, for purposes of determining whether a crypto-asset transaction satisfies the Howey test, the Court must analyze the coin’s “ecosystem,” which consists of the “full set of contracts, expectations, and understandings” surrounding the transaction.  For example, with respect to SOL, the Court noted Solana’s public statements that it would pool proceeds from SOL sales to fund development and marketing efforts to increase participation in the Solana blockchain, and consequently the demand for SOL.

Using this “ecosystem” approach, the Court made the following findings in determining that the pleadings satisfied the Howey test with respect to SOL and Chiliz[5]:

• Adequate pleading of a reasonable expectation of profit solely from the efforts of others.  This expectation comes from issuers and promotors “advertising the ways in which their technical and entrepreneurial efforts would be used to improve the value of the asset,” including by “burning” tokens to ease inflation and reinvesting profits from token sales to improve the token’s blockchain and ecosystem.
• Adequate pleading of a common enterprise via horizontal commonality.  Coinbase users and issuers “were joined in a common, profit-seeking enterprise,” because the users depended upon “both the successful launch of the token and the post-launch development and expansion of the token’s ecosystem” in order to profit.
• Allegations of issuers’ continued efforts to improve asset values after the tokens were available on secondary markets meant that investors in both primary and secondary markets would expect profits solely from the efforts of others.

These findings led the Court to conclude that the SEC had adequately pled that the transactions involving SOL and Chiliz constituted investment contracts and were therefore securities.  Having found that the SEC sufficiently alleged securities, the Court refused to dismiss the SEC’s claims that Coinbase was operating an unregistered exchange and offering unregistered securities in violation of federal securities laws.

The Court also found that the SEC adequately pled violations of Section 5 of the Securities Act of 1933 for the unregistered offer and sale of securities in connection with Coinbase’s Staking Program, through which users “stake” tokens and participate in system computing functions in exchange for potential rewards.  Here, key findings in the Court’s Howey analysis included[6]:

• Participation in the Staking Program was an investment of money.  A participant provides “specific consideration” in the form of tokens, which, while staked, cannot be transacted in reaction to market price fluctuations.  Also, participants’ assets are at risk of loss via “slashing” (a penalty deduction from the staked assets) for underperforming the Staking Program’s system computing functions.
• Importantly, risks that apply not just to Staking Program participants, but broadly to all Coinbase users – such as cybersecurity attacks – suffice to show risk of loss attendant to the Staking Program.
• Participants expected profits based on the efforts of others.  Coinbase undertook “significant post-sale managerial efforts,” including the provision of proprietary software and equipment and the maintenance of reserves to enable quicker participant withdrawals.  Once again, the Court emphasized Coinbase’s marketing, which here highlighted how the Staking Program generated returns for customers.

Of significance was the Court’s rejection of the argument that retail purchases on a secondary market should be categorically excluded from being investment contracts since there is no agreement between the issuer and the retail buyer to join in a common profit-seeking enterprise.  This holding disagreed with the Ripple Labs case,[7] where the court found that the sale of Ripple coins to retail investors on a secondary exchange did not constitute an “investment contract.”  Instead, the Court followed the Terraform Labs decision and considered “what the offeror invites investors to reasonably understand and expect.”  The Court was not concerned, as Defendants were, that the SEC would claim authority over all investment activity absent a contract obligation.  A Coinbase customer, according to the Court, does more than merely purchase a token “which in and of itself is valueless.”  The purchaser is “buying into the token’s digital ecosystem,” the growth of which will likewise grow the token’s value.  According to the Court, a token is not akin to a commodity or collectable, but rather an interest in a broader enterprise.

Coinbase’s sole victory on its motion was dismissal of the SEC’s claim that Coinbase violated Section 15(a) of the Exchange Act by acting as an unregistered broker through its “Wallet” service.  Wallet permits customers to “self-custody” important information about their crypto assets, and facilitates token trading through third-party platforms.  However, the Court found that Coinbase neither controls the assets transacted over Wallet, nor provides the level of routing trades in the manner traditionally carried out by brokers.  We expect that this will cause the industry to develop more products like Wallet, which have a “self-custody” feature.
Indeed, Brian Armstrong, Coinbase’s CEO, focused on the Wallet win, tweeting on the day of the decision: “Great progress on the SEC case – and huge win for self-custodial wallets.”  But the decision does not offer a clear roadmap for currently-outstanding digital assets to be deemed in compliance with federal securities laws.  Rather, the Court’s holistic assessment of a digital asset’s “ecosystem” in its Howey analysis will likely embolden the SEC to continue its campaign of crypto enforcement actions.  And the SEC has shown no sign that rules are forthcoming, having denied Coinbase’s own rulemaking petition.  Although all of these decisions will eventually be addressed by the Second Circuit, this is an area that continues to cry out for legislation from Congress.  The SEC’s current strategy of litigating enforcement on a coin-by-coin basis creates tremendous uncertainty in a multi-trillion dollar industry that continues to see significant growth, as demonstrated by the recent approval of BTC exchange traded product funds.

Sadis & Goldberg has a specialized practice in Digital Assets and Blockchain Technology.  We are available to discuss all matters related to digital asset and blockchain litigation, investments or fund formation.  If you have any questions about the Coinbase decision, this article, or any other digital assets issue, please contact Douglas Hirsch (dhirsch@sadis.com), Sam Lieberman (slieberman@sadis.com), or Frank Restagno (frestagno@sadis.com).