On June 6, 2023, the Securities and Exchange Commission (SEC)
charged Coinbase, Inc. and Coinbase Global, Inc. (Coinbase) with
violations of the Securities Exchange Act of 1934 (“Exchange
Act”) and the Securities Act of 1933 (“Securities
Act”). Coinbase is the largest cryptocurrency exchange in the
United States and has a market capitalization of roughly $24
billion. The SEC’s 101-page complaint, filed in the U.S.
District Court for the Southern District of New York, alleges that
Coinbase operates as an unregistered national securities exchange,
broker, and clearing agency. The SEC further alleges that Coinbase
failed to register the offer and sale of its crypto asset
stakingas-a-service program under Section 5 of the Securities Act,
and that the Coinbase Wallet and Coinbase Prime services offered by
Coinbase constitute broker services under the federal securities
laws.
The SEC’s case against Coinbase is the latest front in the
ongoing regulatory battle over digital assets regulation:
specifically regarding centralized exchanges that allow buyers and
sellers to engage in secondary market transactions in digital
assets. The key issues in the Coinbase litigation revolve around
whether Coinbase, in providing exchange and related services, must
register as an exchange, broker, and clearing agency pursuant to
the Securities Act and the Exchange Act. More generally, the
Coinbase litigation raises questions about when digital assets and
related services, such as staking and interest earning programs,
are securities transactions subject to federal securities laws and
SEC regulation.
I. BACKGROUND: DIGITAL ASSETS AND THE FEDERAL SECURITIES
LAWS
To understand the issues raised by the Coinbase litigation, one
must start with how the SEC and the federal courts have defined the
financial instruments regulated by the federal securities laws. The
definitions of “security” employed by the Securities Act
and the Exchange Act are broad and include a laundry list of
examples, including stocks, bonds, options, fractional interests,
investment contracts, and more.1 Digital assets are not
currently included expressly, but they potentially fall within the
meaning of “investment contracts.” Under the four-part
test established by the U.S. Supreme Court in SEC v. W.J. Howey
Co. (1946) (the “Howey Test”), an investment
contract exists when there is: (1) an investment of money (2) in a
common enterprise (3) with an expectation of profit (4) in reliance
on the efforts of others.
The breadth and flexibility of the Howey Test are key
features. In articulating this test, the Supreme Court held that
the test fulfills “the statutory purpose of compelling full
and fair disclosure relative to the issuance of ‘the many types
of instruments that in our commercial world fall within the
ordinary concept of a security.’ “2 The
adoption of a flexible definition for investment contract extends
investor protections to a wide variety of commercial transactions
beyond the examples listed specifically in the Securities Act and
the Exchange Act, but this choice comes at a cost. The application
of a flexible, fact-specific test forces courts to apply a complex,
case-by-case analysis that can give rise to a regulatory landscape
in which similarlysituated litigants obtain different results in
different courts.3 That outcome seems especially likely
in the digital assets contexts, as courts grapple with how best to
apply Howey to new financial products borne of new
technologies that may not offer clear analogies to traditional
securities.
The SEC has consistently asserted that Howey grants the
Commission broad authority to regulate digital assets. The SEC
first took this position officially when it issued a July 2017
Report of Investigation relating to German company Slock.it, the
creator of a Decentralized Autonomous Organization
(“DAO”) used to issue and sell DAO tokens. The sale of
DAO tokens generated funds that the DAO used to acquire assets and
fund projects that generated returns for DAO token holders.
Meanwhile, DAO token holders also could engage in secondary market
trading of their tokens via several online platforms. The SEC
investigated Slock.it and its cofounders following a 2016
cyberattack against the DAO. While the SEC chose not to take any
enforcement action, the Commission published an investigation
report asserting that the DAO tokens were regulated securities.
Applying the Howey Test, the SEC stated that the tokens were
securities because token purchasers had invested money (i.e.,
Ether) with a reasonable expectation of profits to be made from the
projects that required “significant managerial efforts”
by Slock.it and its cofounders.4 The SEC also took the
position in the DAO investigative report that the platforms used to
trade DAO tokens were exchanges within the meaning of Rule
3b-16(a), were not subject to exemptions, and had to be registered
as such pursuant to Sections 5 and 6 of the
Exchange Act.5
Some two years after the DAO investigation report, the SEC
presented a more detailed explanation of its Howey
approach in its 2019 “Framework for Investment Contract
Analysis of Digital Assets” (2019 Framework). Among other
topics, the 2019 Framework focuses at length on how the SEC
determines whether a purchaser has a reasonable expectation of
profits derived from the efforts of others. The 2019 Framework
indicates that in applying Howey, the SEC will seek to
determine whether (a) the purchaser reasonably expects to rely on
the efforts of a promoter, sponsor, or other relevant third
parties; (b) these third-party efforts are significant and
managerial rather than ministerial; and (c) the purchaser
reasonably expects profits, e.g., capital appreciation, resulting
from the development of the initial investment or business
enterprise, or a participation in earnings resulting from the use
of purchasers’ funds, not mere price appreciation resulting
solely from the supply and demand for the underlying asset. The
2019 Framework provides that secondary sales or offers of digital
assets are subject to the same analysis as an initial sale, plus
additional considerations relating to the ongoing efforts of
others.
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Footnotes
1. See 15 U.S.C.A. § 77b(a)(1) (defining
“security” for purposes of the Securities Act) (“The
term ‘security’ means any note, stock, treasury stock,
security future, security-based swap, bond, debenture, evidence of
indebtedness, certificate of interest or participation in any
profit-sharing agreement, collateral-trust certificate,
preorganization certificate or subscription, transferable share,
investment contract, voting-trust certificate, certificate of
deposit for a security, fractional undivided interest in oil, gas,
or other mineral rights, any put, call, straddle, option, or
privilege on any security, certificate of deposit, or group or
index of securities (including any interest therein or based on the
value thereof), or any put, call, straddle, option, or privilege
entered into on a national securities exchange relating to foreign
currency, or, in general, any interest or instrument commonly known
as a ‘security,’ or any certificate of interest or
participation in, temporary or interim certificate for, receipt
for, guarantee of, or warrant or right to subscribe to or purchase,
any of the foregoing.” See also 15 U.S. Code §
78c(a)(10) (defining “security” for purposes of the
Exchange Act).
2. S.E.C. v. W.J. Howey Co., 328 U.S. 293, 299,
66 S. Ct. 1100, 90 L. Ed. 1244, 163 A.L.R. 1043 (1946) (citing
H.Rep.No.85, 73rd Cong., 1st Sess., p. 11) (further providing that
the Howey Test “embodies a flexible rather than a static
principle” that is “capable of adaptation to meet the
countless and variable schemes devised by those who seek the use of
the money of others on the promise of profits”).
3. See Miriam R. Albert, The Howey Test Turns
64: Are the Courts Grading this Test on a Curve?, 2 Wm. & Mary
Bus. L. Rev. 1, 8 (2011) (available at https://scholarship.law.wm.edu/wmblr/vol2/iss1/2)
(“Indeed, the specter of inconsistent interpretation and/or
application by the lower courts arguably threatens to undermine the
utility of the Howey test itself as a trigger for investor
protection.”)
4. Securities & Exchange Commission, Release No.
81207 (Jul. 25, 2017)
(https://www.sec.gov/litigation/investreport/34-81207.pdf), at
12.
5. Id. The Exchange Act prohibits brokers, dealers, and
exchanges from effecting or reporting securities transactions on a
national securities exchange unless the security and the exchange
are registered or are exempted from registration requirements.
See 15 U.S.C.A. § 78e. Under Section 3(a)(1) of the
Exchange Act, an “exchange” is “any organization,
association, or group of persons, whether incorporated or
unincorporated, which constitutes, maintains, or provides a
marketplace or facilities for bringing together purchasers and
sellers of securities or for otherwise performing with respect to
securities the functions commonly performed by a stock exchange as
that term is generally understood. . . .” Exchange Act Rule
3b-16(a) further provides that an organization, association, or
group of persons shall be considered to constitute, maintain, or
provide “a marketplace or facilities for bringing together
purchasers and sellers of securities or for otherwise performing
with respect to securities the functions commonly performed by a
stock exchange,” if such organization, association, or group
of persons: (1) brings together the orders for securities of
multiple buyers and sellers; and (2) uses established,
non-discretionary methods (whether by providing a trading facility
or by setting rules) under which such orders interact with each
other, and the buyers and sellers entering such orders agree to the
terms of the trade. 15 U.S.C.A. § 78c(a)(1).
6. See William Hinman, Director, Division of Corporate
Finance, Digital Asset Transactions: When Howey Met Gary (Plastic)
(June 14, 2018) (https://www.sec.gov/news/speech/speech-hinm
an-061418). In S.E.C. v. Ripple Labs, Inc., 540 F. Supp. 3d 409
(S.D. N.Y. 2021), the court issued a summary judgement order ruling
that at least certain kinds of digital assets transactions are not
securities transactions. In the order, the court applied the Howey
Test and held that institutional buyers which “knowingly
purchased XRP directly from Ripple pursuant to a contract” had
engaged in securities transactions; “programmatic buyers”
who purchased XRP via a blind sale mechanism did not engage in
securities transaction because, unlike the institutional investors,
they did not purchase XRP with a reasonable expectation of profit
in reliance on the managerial efforts of Ripple. The court further
held that Ripple’s issuance of XRP to employees and other third
parties did not involve the investment of money, and were not
securities under the Howey Test for that reason. The Ripple order
does not address whether secondary sales of cryptocurrencies or
tokens, including sales on exchanges, would be considered sales of
securities, though it does suggest, through its holding on
”programmatic buyers”, that secondary
transactions on exchanges via a blind sale mechanism would not be
securities transactions. Prior to Ripple, courts
addressing whether the offer and sale of digital assets are
securities transactions have generally found that they are. Given
the nature of the Howey Test, these findings are generally
fact-specific and have not given rise to a general rule for the
evaluation of digital assets. See, e.g., SEC v. Kik
Interactive, Inc., Case No. 19-cv-5244 (AKH) (Oct. 21, 2020)
(final judgment resolving SEC charges that Kik’s unregistered
“Kin” token offering violated the federal securities
laws); S.E.C. v. Telegram Group Inc., 2020 WL 1547383, at *1 (S.D.
N.Y. 2020) (holding that while “Gram” token purchase
agreements were not securities by themselves, Telegram’s
pre-sale scheme, including the Gram purchase agreements and related
understandings and undertakings, were securities).
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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