Coinbase Files Brief Asking Court to Dismiss SEC's Lawsuit.
The SEC's filed suit against Coinbase alleging that it breached federal securities laws by failing to register as a securities exchange, broker, and clearing agency. The SEC's complaint persists despite Coinbase's public listing in 2021 and ongoing legislative discussions intended to clarify regulatory jurisdiction over cryptocurrency.
Coinbase counters the SEC’s charges on multiple grounds, among them: the lack of explicit legislative mandate empowering the SEC to regulate crypto exchanges, the perceived overreach and inconsistency of the SEC's interpretation of the securities laws, and the argument that transactions on Coinbase's platform do not meet the legal definition of "investment contracts" and thus fall outside the Securities Act of 1933 and the Securities Exchange Act of 1934. These issues raise fundamental questions about regulatory boundaries and definitions in the rapidly evolving world of digital assets.
In its brief filed on August 4, 2023, Coinbase argues for the dismissal of the SEC’s case based on Federal Rule of Civil Procedure 12©—stating that the SEC's complaint doesn't contain sufficient factual matter to state a plausible claim. The key arguments from Coinbase include:
Absence of Securities Transactions: Coinbase emphasizes that the SEC's claims heavily rely on the argument that trades over Coinbase involving the 12 tokens identified in the complaint are exchanges of "investment contract[s]" or securities. However, Coinbase argues that these transactions do not involve contractual undertakings to deliver future value reflecting the income, profits, or assets of a business. Instead, they are framed as commodity sales with all obligations discharged at the moment of digital token delivery.
Absence of Contractual Undertaking Beyond Point of Sale: Coinbase argues that the SEC's complaint doesn't allege any contractual undertaking to deliver future value beyond the point of sale, which is required to constitute an "investment contract" or a security. They mention that the very definition of an investment contract, as interpreted by courts and the SEC itself in previous instances, implies a contractual arrangement that provides an expectation of deriving profits.
Failure to Confer Contractual Rights to Future Value: The company states that the SEC's complaint does not allege that purchasers of tokens on Coinbase or through Prime had any contractual right to future value. Given the definition of an investment contract, this omission in the SEC's claims is presented as a significant shortcoming. “Coinbase, through its Prime service, allows institutional customers to execute at scale trades of approved assets over the Coinbase spot exchange and other secondary spot exchanges.”
1. The SEC misreads Howey in asserting that a “scheme” without a contractual undertaking will suffice.
Coinbase challenges the SEC's interpretation of the Howey Test— a legal standard used to determine whether certain transactions qualify as "investment contracts." The SEC claims that the presence of a "scheme" alone, even without any contractual agreement, is enough to justify its authority to regulate under securities law.
Coinbase counters in its brief arguing that the SEC's stance is inconsistent with its historical interpretations and is incorrect as a matter of law. The brief argues that the Howey Test, which states that an investment contract means "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party," requires the presence of a contract, not just a scheme.
Coinbase also maintains that the term "scheme" as used in the Howey Test refers to complicated contractual arrangements, using examples of historical cases. In these cases, investments were split into separate agreements, and courts wouldn't hesitate to analyze them together as part of the investment contract. However, the brief argues that this doesn't mean any plan without a contractual obligation can be seen as a "scheme," and that the SEC's interpretation effectively reads the word "contract" out of "investment contract," which contradicts the statutory language and case law.
The brief also states that prior to the SEC's actions against the crypto industry, no court had ruled that a mere investment, accompanied by a hope of value increase but lacking a contractual undertaking, could qualify as an investment contract. It also states that the SEC failed to provide any legal precedent when challenged on this point.
2. Recent crypto cases do not support the SEC’s efforts to use “scheme” as an escape hatch from statutory text.
This section of the Coinbase brief argues that recent cryptocurrency-related cases do not justify the SEC's broad interpretation of the term "scheme" as an alternative to a contractual obligation under the Howey Test. It discusses two cases: SEC v. Kik Interactive Inc. and Terraform, both of which involved actions against token issuers, not secondary market exchanges.
Coinbase argues that in the Kik case (SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169 (S.D.N.Y. 2020), the judge agreed with the SEC that an ongoing contractual obligation is not a necessary requirement for a finding of a common enterprise, which the brief argues contradicts decades of precedent. It also states that the two cases the court cited for this decision both involved contractual schemes with ongoing obligations, and both concluded that the transactions did not involve investment contracts.
Coinbase maintains that the Terraform case (Terraform, 2023 WL 4858299) rejected the argument that an investment contract requires a formal common-law contract, deciding that no enforceable written contract is necessary to establish the existence of an investment contract. The court reasoned that wherever contracting parties agree that an investment will be made in the contractor's profit-seeking endeavor, an investment contract exists. However, the brief argues that this understanding of "scheme" is overly broad and exceeds what the statute and previous case law allow. It also claims that this concept aligns with Coinbase's stance and does not support the SEC's claims.
The brief asserts that the SEC does not allege in its complaint that the parties involved in trades on Coinbase's exchange agreed or schemed that the buyer's payment would be invested in the seller's profit-seeking endeavor, which it suggests the SEC would not be able to prove.
3. The SEC’s effort to portray a simple asset sale as a security is an unprecedented stretch.
Coinbase argues that the SEC is stretching the definition of securities by portraying a simple asset sale as a security, an interpretation they claim is unprecedented.
Coinbase argues that unlike stocks or bonds, digital assets themselves are not securities but can be a component of a security (an investment contract) only if accompanied by relevant contractual undertakings. They point to precedent cases where the subject of the investment contract was a standalone commodity, not an inherent investment contract.
Coinbase uses the example of the SEC suing sellers of gold coins in the 1980s, arguing their promise to deliver coins at a future time constituted an investment contract. The Ninth Circuit disagreed, stating the coins' resulting value depended on the market value of gold at the time of delivery, not the sellers' managerial efforts. They express concern that the SEC's interpretation could apply to any contract where the buyer pays upfront, and the seller's ability to perform depends on their skill and good fortune. See SEC v. Belmont Reid & Co., 794 F.2d 1388, 1391 (9th Cir. 1986) (holding that although the sellers undertook to mine the gold needed to fulfill the contracts, the resulting value to be delivered—the coins—would not be a product principally of the sellers’ managerial efforts but rather of the market value of gold at the time of delivery).
According to Coinbase, the SEC is pursuing a less-grounded theory in this case. On Coinbase's exchange, the purchaser only has a contractual right to ownership of the purchased token. Coinbase contrasts this with other cases, like SEC v. Telegram Group and Kik, where there were contracts for future delivery of tokens. The brief contends that the SEC's case against Coinbase is based solely on spot exchange transactions, which were recently ruled by the Ripple court as not being investment contracts.
Coinbase argues that on their secondary-market exchange, there is no investment of money coupled with a promise of future delivery, only an asset sale. They compare it to the sale of land, a condo, or collectibles, all of which can fluctuate in value post-sale.
Coinbase points out that SEC officials have acknowledged that Bitcoin and Ether, traded on Coinbase, are commodities rather than securities. They argue that there is no principled basis to distinguish transactions in these tokens from the ones the SEC now claims to be securities.
Coinbase concludes that accepting the SEC's interpretation would allow the SEC to turn any sale-of-goods contract into a security, which they argue the Ninth Circuit has previously stated the SEC cannot do.
4. An investment contract requires an expectation in the income, profits, or assets of a business.
Coinbase argues that transactions on Coinbase and through Prime do not constitute investment contracts because purchasers don't acquire a share in the business's income, profits, or assets. It suggests that the SEC's Exchange Act claims are flawed because they don't consider that the potential future value of tokens is unrelated to the profits or assets of the issuer’s business.
The concept of an "investment contract" requires an expectation of income, profits, or assets from a business, according to U.S. legal precedent. Such contracts involve the allocation of capital or money in a way meant to secure income or profit from its usage. This is differentiated from conventional securities like bonds or common stock, which are essentially a debt or equity security.
This understanding of an investment contract is also evident in the Exchange Act. All 28 instruments identified as securities involve investments of capital to be employed by the issuing firm. Unlike traditional commodities which are the product of a company, securities are investments in the company's business. This section argues that the SEC's claims are misguided because the value increase of a business's output isn't part of its "income or profit."
The brief argues that because the SEC does not allege an expectation of income, profits, or assets from any business, the Exchange Act claims are unsustainable. Despite customers buying tokens with hopes of appreciation, it doesn't constitute an investment contract as it does not tie investors' fortunes together, a principle foundational to the concept of a "common enterprise". It criticizes the SEC's interpretation of "capital appreciation" from Edwards, stating that it has traditionally referred to business value appreciation, not the thing the business sells. The section concludes by stating that labelling an output from a business as an "investment contract" contradicts the historical understanding of the term.
5. The Major Question Doctrine
Coinbase argues that the SEC’s interpretation and application of "investment contract" as a means to regulate digital asset transactions, such as cryptocurrencies, falls afoul of the "major questions" doctrine and therefore should be rejected.
The major questions doctrine is a principle of administrative law that maintains that federal agencies should not have the authority to regulate significant aspects of the economy without explicit authorization from Congress. In essence, this doctrine implies that any major policy decisions that could impact a significant portion of the economy must be explicitly authorized by Congress. The doctrine is applied especially when an agency claims authority that it previously acknowledged it does not have.
Coinbase contends that the SEC's attempt to regulate the secondary markets for digital assets—a sector that's worth around $1 trillion and constitutes a "significant portion of the American economy"—does not have clear congressional authorization. The SEC's interpretation of "investment contract" is presented as a novel and problematic expansion that deviates from historical context and agreed-upon meanings.
Coinbase also notes that the SEC has asserted its regulatory authority over digital assets even as Congress is actively considering legislative proposals on how to regulate these assets. This action is seen as overstepping its jurisdiction and undermining the ongoing legislative process, thereby contradicting the major questions doctrine.
6. Is Coinbase’s Wallet Software An Unregistered Broker?
The SEC charges Coinbase with violating the Exchange Act by providing customers with its Wallet software, allegedly behaving like a securities broker without appropriate registration. However, Coinbase argues that the SEC has not provided any evidence that the tokens accessible via the Wallet, such as NEXO, are "investment contracts". Furthermore, Coinbase argues that the SEC has failed to demonstrate how Coinbase acts as a broker through its Wallet.
In legal terms, a broker is defined as someone who transacts securities for others, with various activities potentially demonstrating broker-like behavior. However, according to Coinbase, the SEC has not substantiated any claims that Coinbase performs such relevant activities through its Wallet.
Coinbase describes its Wallet as passive software that enables customers to store their private keys for digital assets on their devices, with customers maintaining control and custody of their assets at all times. Coinbase's Wallet software connects to third-party platforms, including decentralized exchanges, but the company maintains that it performs no key trading functions for users in connection with these activities.
Lastly, Coinbase addresses the SEC's allegations regarding the commissions it received on certain transactions involving digital assets in the Wallet, arguing that commission-based payment alone does not constitute broker-dealer activity under the Exchange Act. The company emphasizes that it no longer receives fees connected to customers' use of its Wallet software. Coinbase concludes by stating that the SEC has failed to present allegations that could validate their claim of Coinbase acting as a broker.
7. Do Coinbase’s Staking Services Constitute Unregistered Securities?
Coinbase argues that its staking services don't constitute unregistered securities and therefore, the SEC's claim fails. The company highlights two independent reasons for this:
Coinbase's staking services don't involve an investment of money: The company argues that staking is not an investment since it doesn't involve the risk of loss which is crucial for an instrument to be considered a security. Coinbase insists that the potential risks highlighted by the SEC, such as potential cybersecurity attacks, loss of private keys, and smart contract failures, are unrelated to the staking service. The company also asserts that the customers retain ownership and control of their assets throughout the staking process, thus it does not involve an investment of money.
Profits from Coinbase's staking services are not due to managerial services: Coinbase asserts that staking rewards are not investment profits but are payments for participating in the blockchain validation process. These rewards are set by the network protocols and are the same irrespective of whether customers stake through Coinbase or on their own. The SEC's claims that Coinbase’s managerial efforts influence the returns from staking are incorrect since once the technical setup is done, Coinbase doesn't have any control over the staking rewards which are determined entirely by the token's blockchain protocol.
Coinbase concludes by stating its support for additional regulations in the digital asset industry and welcoming new regulatory rules. However, it insists that any regulation should be fair, transparent, and lawful. It suggests that the SEC's lawsuit is an abrupt and unexplained change in agency position, and an overstep of its statutory authority. Hence, it argues that the case should be dismissed.