The decision, which addresses a broad range of market activity by Coinbase relating to 13 third-party tokens, could have significant implications for market participants.
By Latham & Watkins’ Litigation & Trial Practice
On March 27, 2024, Judge Katherine Failla of the US District Court for the Southern District of New York (SDNY) ruled[i] (the Ruling) in favor of the Securities and Exchange Commission (SEC) on all but one argument raised in Coinbase’s motion for judgment on the pleadings, finding that the Commission adequately alleged the tokens at issue and Coinbase’s staking services are securities and that Coinbase has been operating as an unregistered broker, exchange, and clearing agency.
The Ruling followed significant recent decisions in two other high-profile SEC enforcement actions regarding cryptocurrencies: SEC v. Ripple Labs, Inc., No. 1:20-Civ-10832 (SDNY), and SEC v. Terraform Labs Pte. Ltd., No. 1:23-cv-01346 (SDNY). The Coinbase decision, however, may be the most significant among the three decisions because (1) it addresses a broader range of market activity by a token exchange (as opposed to an issuer) and 13 third-party tokens (as opposed to fewer tokens from a single issuer), and (2) Judge Failla’s Ruling addresses the prior decisions in Ripple and Terraform and thus serves as the latest, most comprehensive opinion to date in the canon of case law on the issues.
In Ripple, Judge Analisa Torres ruled on July 13, 2023, that Ripple’s direct token sales to institutional investors (Institutional Sales) constituted securities transactions, but sales on digital asset trading platforms (Programmatic Sales) did not. That distinction primarily hinged on whether, for each type of transaction, investors reasonably expected that Ripple would use their funds to increase the value of XRP, Ripple’s native token.[ii] Judge Torres reasoned that, while Institutional Sale buyers reasonably expected Ripple to use their funds to improve Ripple’s crypto ecosystem, thereby increasing the price of XRP, Programmatic Sale buyers could not reasonably expect the same because as secondary market purchasers they did not know that their money would go to Ripple. Judge Torres also found that distributions of tokens to Ripple employees in exchange for services and sales of tokens on digital asset trading platforms by Ripple’s senior leadership were not securities transactions. The SEC moved to certify for interlocutory appeal portions of Judge Torres’ decision, which Judge Torres denied on October 3, 2023.
In Terraform, Judge Jed Rakoff ruled on July 31, 2023, that the SEC had adequately pleaded that Terraform’s sales of various native cryptoassets were investment contracts. Judge Rakoff explicitly rejected Judge Torres’ approach in Ripple, finding no distinction between direct sales to institutional investors and secondary-market sales to retail investors in terms of whether investors had a reasonable expectation of profits from their contributions of funds. In doing so, Judge Rakoff found significant the allegation that defendants had represented to investors that “sales from purchases of all crypto-assets – no matter where the coins were purchased – would be fed back into the Terraform blockchain and would generate additional profits for all crypto-asset holders.” This represented a break from Judge Torres’ view that only direct purchases by institutional buyers could reasonably be expected to contribute to the development of the issuer’s crypto ecosystem.
The Coinbase decisionbuilds on Terraform, again rejecting the distinction between direct and secondary-market sales identified in Ripple and holding that the SEC adequately alleged all 13 third-party tokens constituted investment-contract securities. It also holds that Coinbase has been operating as an unregistered broker, exchange, and clearing agency with respect to those assets, as well as offering unregistered securities with respect to its staking service. The court granted Coinbase’s motion with respect to the SEC’s allegations that Coinbase’s “Wallet” service constituted brokerage services under the federal securities laws. However, that win for Coinbase was overshadowed by the rulings for the SEC on all other issues.
As detailed further below, this order — unless upended by future decisions in this case or other actions in this space — will be cited by the SEC as important precedent for its enforcement activity in this area and could be an obstacle for market participants potentially subject to SEC oversight.
Overview of Coinbase Allegations
In Coinbase, the SEC alleged that Coinbase and its holding company committed securities violations by failing to register as an exchange, broker, and clearing agency in violation of Exchange Act Sections 5, 15(a), and 17A(b), while offering trading in 13 third-party tokens claimed by the SEC to be securities. The SEC also alleged that Coinbase’s staking program (which deploys users’ assets in blockchain validation processes in exchange for protocol-driven fees) constitutes an unregistered securities offering under Sections 5(a) and 5(c) of the Securities Act. The SEC also alleged that Coinbase’s wallet software (which helps users self-custody digital assets and deploy them elsewhere) also supports the SEC’s unregistered broker claim against Coinbase.
Rather than move to dismiss the complaint, Coinbase answered it and moved for judgment on the pleadings. That motion argued that the SEC had failed to plead the presence of any “investment contracts” (the only type of security alleged to be on Coinbase’s platform) under the seminal case of SEC v. W.J. Howey Co., 328 U.S. 293 (1946), primarily because the SEC had not pled the existence of any contractual relationships between the third-party token issuers and secondary buyers on Coinbase. Defendants also argued that the SEC’s “investment contract” interpretation is precluded under the major questions doctrine (MQD) — a rule of statutory construction that disfavors agency interpretations that result in significant economic or political impact absent clear congressional authorization. Defendants argued that the SEC’s interpretation deprived defendants of due process, because the SEC had not provided fair notice of such “investment contract” interpretation.
Summary of Opinion
Judge Failla largely ruled in favor of the SEC, rejecting Coinbase’s MQD and fair notice defenses. She found that transactions in the 13 third-party tokens — even without contractual relationships between such tokens’ issuers and the secondary buyers on Coinbase — were sufficiently pled to be “investment contracts” under the test articulated in Howey (i.e., that such transactions involve “an investment of money in a common enterprise with profits to come solely from the efforts of others.”[iii] Judge Failla also agreed with the SEC that Coinbase’s staking program could constitute an “investment contract” too, notwithstanding defendants’ arguments that users’ deposits of digital assets into Coinbase’s staking program do not satisfy the “investment of money” prong of the Howey test. Finally, Judge Failla rejected the SEC’s allegations that Coinbase acted as a broker through its wallet software.
Major Questions Doctrine
In rejecting Coinbase’s MQD defense, Judge Failla found that, “while certainly sizable and important, . . . the cryptocurrency industry cannot compare with those other industries the Supreme Court has found to trigger the major questions doctrine.” In making that determination, Judge Failla noted that “the securities industries over which Congress has expressly given the SEC enforcement authority are even broader than the markets for cryptocurrencies, and implicate larger portions of the American economy.” Judge Failla went further, seeming to agree with the SEC’s arguments that enforcement actions are less likely to implicate the MQD than other agency conduct; the “very concept of enforcement actions evidences the Commission’s ability to develop the law by accretion.”
Fair Notice Defense
In rejecting Coinbase’s fair notice defense, Judge Failla pointed to prior SEC guidance that digital assets may constitute “investment contracts,” including the 2017 DAO Report and the 2019 Framework for “Investment Contract” Analysis of Digital Assets. Judge Failla agreed with the SEC that fair notice was further evinced by, among other things, defendants’ own actions in trying to keep securities off of Coinbase.[iv]
Howey Analysis — Third-Party Tokens
Before determining that transactions in the 13 third-party tokens were sufficiently alleged to be “investment contracts,” Judge Failla conducted a brief survey of prior crypto rulings and adopted principles that some of those courts had devised in conducting their Howey analysis: (1) “there need not be a formal contract between transacting parties for an investment contract to exist under Howey,” (2) “when conducting the Howey analysis, courts are not to consider the crypto-asset in isolation . . . courts evaluate whether the crypto-assets and the ‘full set of contracts, expectations, and understandings’ surrounding its sale and distribution – frequently referred to using the shorthand ‘ecosystem’ – amount to an investment contract,” and (3) “in assessing the circ*mstances surrounding the sale of a crypto-asset, courts should look to what the offeror invites investors to reasonably understand and expect [by] examin[ing] how, and to whom, issuers or promoters market the crypto asset.”
Because “Defendants d[id] not dispute that purchasers of the Crypto-Assets make an ‘investment of money,’” the court’s application of the above principles “focus[ed only] on the two remaining Howey prongs.” In conducting that analysis, Judge Failla found that “the SEC has plausibly alleged horizontal commonality” — the US Court of Appeals for the Second Circuit’s test for Howey’s “common enterprise” prong — because “token issuers, developers, and promoters frequently represented that proceeds from crypto-asset sales would be pooled to further develop the tokens’ ecosystems and promised that these improvements would benefit all token holders by increasing the value of the tokens themselves.” The court found that those representations and promises (and other public statements, marketing claims, and token features, such as those relating to token burning) also supported a finding that the tokens satisfied Howey’s “expectation of profits” prong.
In so ruling, Judge Failla disagreed with Coinbase that non-contractual secondary sales of digital assets cannot be “investment contracts”: “there is little logic to the distinction Defendants attempt to draw between the reasonable expectations of investors who buy directly from an issuer and those who buy on the secondary market. An investor selecting an investment opportunity in either setting is attracted by the promises and offers made by issuers to the investing public.” In stressing similarities in the “expectation of profits” between primary and secondary purchasers, Judge Failla largely followed Judge Rakoff’s reasoning in Terraform, rejecting Judge Torres’ reasoning in Ripple. Judge Torres had found no reasonable Howey “expectation of profits” for blind bid/ask transaction purchasers, who “could not have known if their payments of money went to [the relevant issuer].” With respect to Coinbase’s argument that an “investment contract” requires a contract, Judge Failla’s review of the case law led her to conclude that “since Howey, no court has adopted a contractual undertaking requirement. . . This Court declines to be the first.”
Howey Analysis — Staking Program
Judge Failla found that the risks of loss associated with Coinbase’s staking program were sufficient to support a Howey “investment of money,” even though “such downsides might be remote” and “even if [they] appl[y] broadly to all Coinbase customers (not just staking participants), and even if the risk applies equally to” people staking on their own or through non-Coinbase staking programs. Put simply, the court found that “risks need not be promoter-specific to constitute a risk of loss for purposes of the Howey test.” Judge Failla also found that “Howey imposes no requirement that investors give up permanent ‘ownership’ over the capital invested in the enterprise,” and that opportunity costs tolled during periods of non-control can constitute “specific consideration” adequate to support an “investment of money.” Judge Failla also rejected defendants’ argument that the efforts Coinbase exerts to run its staking program are only ministerial in nature, and therefore are not cognizable from a Howey “expectation of profits” “to come solely from the efforts of others” perspective.[v]
Unregistered Broker Claim — Coinbase Wallet
Judge Failla agreed with Coinbase that, as alleged, its participation “in the [decentralized exchange] order-routing process [of Coinbase Wallet users] is minimal,” and therefore cannot support the SEC’s claim that Coinbase is an unregistered broker through such software.[vi]
Conclusion
Judge Failla’s Ruling in Coinbase may prove to have significant implications for the cryptocurrency industry. The court not only ruled in the SEC’s favor on its allegations that the 13 tokens at issue are securities, but also endorsed significant aspects of the broad reading of the Howey test in Terraform. The Ruling therefore supplies precedent that the SEC and private litigants may use in future actions relating both to these tokens and countless others which may share some of their characteristics. Further, because this action concerns a third-party exchange — as opposed to the narrower token-issuer cases which preceded it — the decision raises the risk profile for other institutions that perform similar functions in the industry.
Yet this decision is not the end of the road in this case or others. The significance of the issues at play for the defendants in these cases, and the apparent conflict in the application of Howey between the Coinbase and Terraform courts on the one hand and the Ripple court on the other, sets up likely appellate issues for the Second Circuit in one or more of these cases. Notably, the Coinbase Ruling is not appealable as of right, but on April 12, 2024, Coinbase filed a motion to certify interlocutory appeal of the court’s decision, which is now pending.[vii] Setting aside appellate issues, the SEC will still need to prove its claims against Coinbase after discovery, summary judgment, and trial. As was the case in Ripple, these proceedings may take years to unfold.
As this case and others pending in the SDNY and other courts around the country continue to develop, market participants must continue to navigate an evolving regulatory landscape in a rapidly developing industry.
Endnotes
[i] SEC v. Coinbase, No. 1:23-cv-04738 (SDNY).
[ii] See Ripple, ECF No. 874, at 16-25.
[iii] Howey, 328 U.S., at 301), see id. at 40-60.
[iv] See Ruling, at 37-38 (“Defendants admit that – in accordance with SEC guidance – they ‘established a systematic analytical process for reviewing crypto assets’ specifically to determine which ‘could be deemed ‘securities’ under the SEC’s definition.’”).
[v] See id. at 77 (“While it remains the case that customers can stake on their own, Coinbase’s arguments to this Court downplaying the economic and technical barriers to solo staking stand in sharp contrast to Coinbase’s representations to its customers of the significant efforts it exerts to offer and market those features that differentiate the Coinbase Staking Program from staking independently”).
[vi] Ruling, at 82-83 (“The SEC does not allege that Coinbase performs any key trading functions on behalf of its users . . . Coinbase has no control over a user’s crypto-assets or transactions via Wallet ... while Wallet helps users discover pricing on decentralized exchanges, providing pricing comparisons does not rise to the level of routing or making investment recommendations.”).
[vii] SEC v. Coinbase, No. 1:23-cv-04738, Dkt. 109 (SDNY).
