Legal Battle Between Coinbase and the SEC unfolds in Court

On Wednesday, a federal judge in Manhattan closely examined Coinbase (COIN.O) and the U.S. securities regulator, questioning their differing perspectives on the classification of digital assets as securities and the timing of such categorisations.

This case, which holds significant importance for the cryptocurrency industry, involves Coinbase seeking dismissal of the Securities and Exchange Commission’s lawsuit accusing the largest U.S. crypto exchange of violating its regulations.

The regulatory agency contended that 13 tokens featured on the platform were deemed securities. These included coins such as Solana (SOL), Cardano (ADA), Polygon (MATIC), Filecoin (FIL), The Sandbox (SAND), Axie Infinity (AXS), Chiliz (CHZ), Flow (FLOW), Internet Computer (ICP), NEAR (NEAR), Voyager (VGX), Dash (DASH), and Nexo (NEXO).

During the proceedings, Judge Katherine Polk Failla listened to arguments from both parties, with a particular focus on the legal precedents defining securities. She also delved into the characteristics of various crypto tokens traded on Coinbase and other platforms, which the regulator has identified as investment contracts.

Failla also scrutinised the Securities and Exchange Commission’s case against the cryptocurrency exchange, pressing SEC attorneys to clarify why a digital token issuance would satisfy the Howey test and suggesting that the case was overly broad.

The SEC contends that token buyers are essentially investing in the underlying network or ecosystem, implying a value proposition tied to token acquisition. Coinbase’s legal team countered this argument by asserting that Bitcoin, characterised as a commodity by an SEC attorney during the hearing, also possesses community support and a network.

Judge Failla additionally explored the definitions of staking and secondary market transactions, drawing parallels to recent court decisions involving cryptocurrency firms, such as the Ripple and Terraform Labs case.

SEC attorneys contended that the exchange is attempting to establish a modified version of the Howey test while permitting the trading of crypto tokens that confer access to ecosystems described by the regulator as a “common enterprise.”

The SEC asserted that the exchange independently applied the Howey test, resulting in varied interpretations of certain tokens’ status. According to the SEC, this divergence in conclusions regarding the test provides ample justification to reject the motion and proceed with the case.

“We think they’re making up a new test, and we believe that our position is the one that’s most faithful and consistent, but in fact, compelled by the Howey test. It’s not just a plausible reading, as they claim it is.”

In the course of the hearing, the SEC brought up a recent judgement concerning Terraform Labs, determining that the company sold digital assets as securities without proper registration. According to the SEC, this ruling served as additional support for its case against Coinbase.

The matter was extensively deliberated during the hearing. According to SEC attorneys, although the circumstances of Ripple and Terraform Labs may differ from those of Coinbase, the application of the Howey test remains precisely the same.

“Our perspective is they’re identical in terms of the Howey test that applies,” stated the SEC. “We think Coinbase is trying to create a different Howey test for when the people at this table might sell the tokens to each other on its platform and when Terraform might sell its tokens on Coinbase’s platform. And we think that’s just wrong, your honour.”

The legal representatives for Coinbase contended that the case of Terraform Labs did not encompass secondary market transactions, unlike those occurring on the Coinbase platform. Another notable distinction highlighted in court was that, in the dispute involving Terraform Labs, investors and the company were engaged in a private relationship.

“But the Terraform case, first of all, as I know the court knows, did not involve secondary market transactions… There were no secondary market transactions in that case. […] Those were all situations where there was a relationship between the investor and the promoter.”

Furthermore, the legal representatives for Coinbase examined the legal prerequisites for establishing an investment contract under U.S. law. This entails a financial arrangement where an individual invests money in a venture overseen by another party with the anticipation of generating a profit.

“An investment contract, at a minimum, requires the contracting parties to agree or scheme together that the contractee will invest in the contractor’s profit-seeking endeavour.”

As per Coinbase, individuals engaging in token trading on its platform may pursue profit on their investment, although tokens can also be acquired for their utility. Judge Failla further noted that investors might purchase tokens for reasons such as finding them “cool” or due to the ownership by a friend.

Moreover, Coinbase asserted that individuals holding tokens do not receive dividends or possess legal rights over a project solely by virtue of owning tokens, a distinction from the characteristics of stocks.

“A stock reflects an interest in the permanent capital of a corporation. And when it trades, that interest in the permanent capital of the corporation, which is a participation in its capital structure, transferred in entirety from one holder to another holder.”

The discourse on stocks and cryptocurrency tokens originated from the July 2023 ruling on Ripple. During this ruling, Judge Analisa Torres issued a summary judgement favouring Ripple Labs, establishing that the XRP token is not considered a security when sold through programmatic sales on exchanges. However, Judge Torres also concluded that XRP qualified as a security when sold to institutional investors, aligning with the criteria of the Howey Test.

“The critical takeaway there is that Judge Torres recognised that secondary market token purchases of XRP were not investing in Ripple. And in that sense, it rejected what I think is a core portion of the Commission’s argument before the court today, which is its investment in an ecosystem, at least with respect to transactions between strangers, where no relationship exists, where no obligations travel.”

According to Coinbase’s perspective, anonymous transactions among individuals on its platform do not qualify as an investment agreement.

Will Gary ever leave us alone?

Probably not.