Coinbase Court Embraces ‘Ecosystem’ Approach To Identifying Crypto-Asset Securities – Fin Tech

Key Points

• In a thorough decision, a federal district judge in New York
  largely denied Coinbase’s motion for judgment on the pleadings
  in a case brought by the SEC. Applying the plaintiff-friendly
  standards required at the pleading stage, the court accepted the
  SEC’s factual allegations as true and concluded that the SEC
  plausibly alleged that Coinbase violated the federal securities
  laws through its involvement in crypto-asset transactions involving
  investment contracts.




• In doing so, the court embraced Judge Rakoff’s approach to
  analyzing crypto-asset transactions in the Terraform
  litigation. The Coinbase decision comes amidst another
  strong bull run for the crypto market and after the SEC’s
  January 2024 approval of spot Bitcoin ETFs, which have seen
  billions of dollars of in-flows.¹




• The bulk of the SEC’s case will now proceed to discovery,
  and time will tell whether the SEC can prove its claims that
  Coinbase operates an unregistered securities exchange,
  broker-dealer and clearing agency, and that its staking program
  effects unregistered offers and sales of securities.

Factual Background

The Coinbase Platform, launched in 2012, allows customers to
buy, sell and trade more than 260 digital assets.²
Coinbase also offers a service called Prime, which allows
institutional customers to execute large-volume trades across
digital asset markets connected to Coinbase’s platform.
Coinbase’s staking program allows customers to transfer
crypto-assets to be staked by Coinbase in return for pro
rata rewards. Coinbase’s Wallet application allows retail
and institutional customers to store and access crypto-assets on
personal devices and links to third-party, decentralized trading
platforms for sending, receiving and swapping tokens, among other
functions.

In June 2023, the U.S. Securities and Exchange Commission (SEC)
sued Coinbase for numerous violations of the federal securities
laws. Since the start of the litigation, Coinbase had argued in
court filings, public commentary and a lawsuit filed against the
SEC (seeking rulemaking for crypto-assets) that the SEC’s
enforcement action had no support under the law, including because
the SEC declared Coinbase’s S-1 effective in 2021, thus
permitting the direct listing of Coinbase securities on the
NASDAQ.

Overview of the Court’s Decision

On March 27, 2024, in a highly anticipated decision, Judge
Katherine Polk Failla of the Southern District of New York largely
rejected Coinbase’s motion for judgment on the pleadings. In an
84-page
opinion, taking the SEC’s factual allegations as true for
purposes of the analysis, the court concluded that the SEC had
plausibly alleged crypto-asset transactions involving investment
contracts under SEC v. Howey and, therefore, that Coinbase
had been involved in “securities” transactions for
purposes of the SEC’s claims under the Securities Act of 1933
and the Securities Exchange Act of 1934. Judge Failla applied the
longstanding Howey test to identify crypto-asset
securities, stating that “the challenged transactions fall
comfortably within the framework that courts have used to identify
securities for nearly eighty years.”³

Like Judge Rakoff in Terraform, Judge Failla held that
Coinbase’s operations, as alleged by the SEC, plausibly involve
investment contracts even though the SEC did not argue that
individual crypto tokens are themselves securities. The decision
bolsters the SEC’s effort to regulate crypto-asset transactions
and does not follow the approach of SEC v. Ripple, which
distinguished between primary and secondary market transactions for
purposes of SEC jurisdiction. Judge Failla did throw out one aspect
of the SEC’s claims against Coinbase: regarding the Wallet
application, she held that the SEC had not plausibly alleged
broker-dealer activity by Coinbase as defined under Section 15(a)
of the Securities Exchange Act.

The Court’s Application of Howey

Judge Failla’s decision features an SEC-friendly,
“ecosystem” approach to applying the Howey test
to alleged crypto-asset transactions, finding that the SEC
plausibly alleged that:

• At least some of the past transactions on the Coinbase Platform
  and through Coinbase Prime involved investments of money in a
  common enterprise with the expectation that profits would be
  derived solely from the efforts of others.




• Purchasers of crypto-assets through Coinbase engaged in a
  common enterprise with developers and other investors because all
  of them depended on the success of an asset’s ecosystem to
  profit from their investments, noting that, “[i]f the
  development of the token’s ecosystem were to stagnate, all
  purchasers of the token would be equally affected and lose their
  opportunity to profit.”⁴




• “[I]ssuers, developers, and promoters frequently
  represented that proceeds . . . 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….”⁵




• Purchasers had a reasonable expectation of profit from the
  efforts of others because, from an objective perspective, investors
  were led to believe they could earn a return on their investment
  solely by third-party efforts to develop and promote the
  ecosystem.

Judge Failla emphasized that issuers, developers and promoters,
through websites, social media posts, investor materials, town
halls and other communications, encouraged both primary and
secondary market investors to buy tokens “by advertising the
ways in which [the developers’] technical and entrepreneurial
efforts would be used to improve the value of the
asset[s].”⁶ She noted that these communications
continued long after assets were made available to retail
investors, and that Coinbase allegedly rebroadcast some of them
through white papers and other materials made available on its
platform.

The court found additional support for the conclusion that
investors reasonably expected to profit from third-party efforts
based on statements made by developers and promoters that
deflationary strategies would support the prices of the underlying
tokens and that profits from sales in the secondary market would be
fed back into the ecosystem. The court recognized that developers
could “theoretically” avoid promoting an ecosystem to
retail investors after making sales on the primary market, but
concluded that, with respect to the transactions alleged in
Coinbase, the developers encouraged both institutional and
retail investors to buy their tokens.⁷

The court found that Coinbase’s staking program, as alleged,
involves transactions in securities because the tokens are
transferred, pooled and staked by Coinbase with an expectation of
profits from Coinbase’s management and technical abilities, and
concluded that the SEC can pursue its claim that both Coinbase and
its parent company, Coinbase Group, Inc. (CGI), can be held liable
because CGI plausibly exercises power and control over
Coinbase’s management and direction.

Takeaways

The case is a significant victory for the SEC’s push for
jurisdiction over transactions involving crypto-assets, and we
expect it to influence other pending actions, including the
Kraken litigation.

The approach taken in Coinbase and Terraform
focuses on a broad universe of offers, promises, communications,
understandings and other circumstances “surrounding”
crypto-asset transactions, including past and ongoing advertising,
social media posts and rebroadcasting of information by exchanges.
It reflects a more expansive view of SEC jurisdiction than the
manner-of-sale approach taken in Ripple.

With the case now progressing past the pleading stage of the
litigation, the SEC will be put to the task of proving its
allegations through fact and expert discovery.

Footnotes

1. Killa, Sweta. Spot Bitcoin ETF
(IBIT) Tops $10 Billion in Aum. Nasdaq, March 6, 2024,
http://www.nasdaq.com/articles/spot-bitcoin-etf-ibit-tops-$10-billion-in-aum.

2. The Coinbase litigation
involves transactions mediated by Coinbase, including transactions
involving 13 crypto-assets with the trading symbols SOL, ADA,
MATIC, FIL, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH and NEXO
(and notably not including crypto tokens such as Bitcoin and
Ethereum, which have been classified as commodities by other
federal judges).

3. Order at 2.

4. Id. at 49 (citing
Terraform 1, 2023 WL 4858299, at *13).

5. Id. at 48.

6. Id. at 51.

7. Id. at 55.

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