Coinbase armed for legal clash over how crypto is regulated

by Arthur · April 28, 2023

Coinbase Global Inc. said Thursday it would fight the Securities and Exchange Commission over the agency’s allegation that much of its business is illegal and try to convince a court that Wall Street regulators lack the authority to oversee cryptocurrency markets.

The company outlined its legal strategy in a memorandum formally responding to the SEC’s earlier notice of a potential enforcement action against the company. The memo, released by Coinbase along with a video featuring the CEO, underscores the company’s efforts to generate political and public support for the confrontation with the SEC.

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An SEC lawsuit against Coinbase would threaten the unregulated business model of crypto exchanges, which contributed to their early profitability and rapid growth. If Coinbase loses, it could be forced to register parts of its business with regulators or delist many crypto tokens that regulators say are securities that should comply with investor protection rules.

Gary Gensler, the SEC’s chairman, told House lawmakers last month that crypto exchanges are largely out of compliance with the laws they are supposed to follow. They may need to remove many tokens they offer and restructure their business to fit SEC rules designed to limit conflicts of interest and other risks for investors, he said.

The regulatory feud comes as Coinbase struggles to make money amid a broader downturn in cryptocurrency markets. The company posted four consecutive quarterly losses as lower prices for assets such as bitcoin hurt revenue and trading volumes fell.

Lower trading volume has hurt Coinbase’s transaction revenue, the lion’s share of the company’s total net revenue over the past two years. Its other revenue streams from staking — where investors earn returns on locking crypto — and interest income on a cryptocurrency pegged to the dollar, USD Coin, are also under threat as regulators go after staking. The market value of USD Coin has fallen by $10 billion since the start of last month’s banking crisis.

The SEC in March told Coinbase that regulators are likely to allege that the company operated a securities exchange, a brokerage firm and a clearinghouse in violation of federal law. It also said Coinbase sold assets that should have been registered as securities. Registration usually requires providing buyers with audited financial statements and risk disclosures.

Coinbase says that the hundreds of cryptocurrencies on its exchange are not securities, and that it has repeatedly explained its token listing process to the SEC. So far, SEC officials have only admitted that bitcoin, which accounts for 29% of Coinbase’s transaction revenue, is not a security.

“I don’t think there’s any dispute about the company, but it’s critical to the industry as a whole that we get clarity on what assets can be offered in the US and on what terms,” said Paul Grewal, Coinbase’s general counsel. interview.

Gensler has disputed that the laws are not clear. “Crypto markets suffer from a lack of regulatory compliance,” Gensler said in an online video Thursday. “It’s not a lack of regulatory clarity.”

Coinbase CEO Brian Armstrong and Mr. Grewal released their own four-minute video, part of an unusual PR strategy to fend off the SEC. The executives turned to the SEC’s five commissioners, who must vote to approve any enforcement action the agency will take.

A lawsuit “at this stage, when there’s not a clear rulebook, is not constructive, and it’s not good for America,” Armstrong said.

The SEC has been waging an enforcement campaign against crypto since late 2017, with activity accelerating following the collapse of global crypto exchange FTX. Prosecutors have since accused FTX’s founders of having committed fraud. While most crypto companies settled with the SEC instead of going to court, a few have taken their chances in litigation.

Ripple Labs Inc. has been suing the SEC over the sale of the XRP cryptocurrency since 2020. A federal judge could make a final decision on the case in the coming months.

A lawsuit against Coinbase would put more pressure on the industry to heed Gensler’s call to comply with SEC rules. Despite the SEC filing over 100 crypto-related enforcement actions in seven years, many crypto firms continue to insist that securities laws are ill-suited to regulate digital assets.

“Regardless of the outcome of litigation between the SEC and Coinbase, companies will undoubtedly find solutions,” said Robert Stern, a partner at Weil, Gotshal & Manges LLP who has represented crypto firms. “So I’m not sure this is the be-all, end-all of whether the SEC will be able to regulate this space the way Chairman Gensler wants it to.”

Much of Coinbase’s response to the SEC’s lawsuit notice claims that regulators have refused to list the digital assets as securities. The firm said a court should also consider whether regulators even have the authority to regulate crypto assets.

Coinbase said a legal test, known as the main issue doctrine, invoked last year by the Supreme Court casts doubt on that authority. This doctrine limits federal agencies from taking steps of enormous economic and political significance without what the majority of the Court considers explicit direction from Congress.

An SEC spokesman declined to comment on Coinbase’s memo, noting that the agency does not recognize investigations until a lawsuit is filed.

“The threat of pending litigation appears to be intended to pressure Coinbase into accepting claims that the Commission simply does not have the authority to order,” Steven Peikin, a lawyer for Coinbase, wrote in the response memo to the SEC.

Mr. Peikin oversaw the SEC’s enforcement program from 2017 to 2020, including many of its early actions against crypto companies. Mr. Peikin is now a partner at Sullivan & Cromwell LLP, the law firm that also employs Jay Clayton, who ran the SEC during the Trump administration and started the SEC’s anti-crypto enforcement campaign.

An SEC lawsuit against Coinbase could test regulators’ reliance on a 76-year-old Supreme Court test known as Howey to regulate many crypto projects. The Howey case dealt with the sale of an “investment contract,” a type of security regulated by the SEC.

Coinbase says the Howey test covered a company’s first sale of an asset, and regulators haven’t proven why it should govern token trading on secondary markets. Losing on that theory would decimate the SEC’s ability to regulate cryptocurrencies, which most investors access through exchanges.