Why Coinbase Will Lose Its Battle With the SEC (Wells Notice Edition)

For Coinbase, It's SEC Showtime.

According to Coinbase, the enforcement staff of the U.S. Securities and Exchange Commission (SEC) wants to charge Coinbase with violations of the U.S. securities laws relating to assets listed on Coinbase's crypto platform and Coinbase's staking and wallet services.

This should come as no surprise. Coinbase has remained defiant and has, time and again, dared the SEC to sue them. My view remains and has been for quite some time, that Coinbase’s operations showcase a veritable driver’s-ed film of securities law violations.

Specifically, after what Coinbase declares was a "cursory SEC investigation" (first disclosed by Coinbase in its June 30, 2022 Form 10-Q), Coinbase this week disclosed that it has received a letter from the SEC known as a Wells Notice.

Per a March 22, 2023, SEC Form 8-K disclosing Coinbase’s receipt of the Wells Notice, Coinbase reports that the SEC believes that the SEC’s potential enforcement action against Coinbase “would relate to aspects of the Company’s spot market, staking service Coinbase Earn, Coinbase Prime and Coinbase Wallet,” and that “the potential civil action may seek injunctive relief, disgorgement, and civil penalties.”

A Wells Notice is when the SEC enforcement staff reaches out to Coinbase notifying Coinbase that the SEC enforcement staff intends to recommend to the SEC Commissioners that the Commissioners authorize the SEC to file a civil lawsuit against Coinbase for certain securities law violations. The Wells Notice gives Coinbase the opportunity to file a memorandum, brief or even a video advocating why the SEC Commissioners should not approve the SEC enforcement staff's recommendation.

Wells Notices are a critical part of the SEC enforcement investigative process, and indicate that the investigation has likely concluded and the staff is considering a charging recommendation to the SEC Commissioners, who must authorize any SEC lawsuits or SEC enforcement settlements.?The SEC never comments on even the existence of an SEC investigation so the only news anyone will hear about a Wells Notice will emanate from the recipient of the Wells Notice (in this situation, Coinbase).

Rather than respond to the Wells Notice privately, as most companies would do, Coinbase, as per usual, instead immediately went into full offensive mode and laid out their defenses on Twitter and elsewhere in an attempt to rally the mob, and publicly shame the SEC into backing off. For whatever reason, Coinbase believes a Twitter rant against the SEC (who will never respond, unless it is with a lawsuit) is the best way to do battle against a Wells Notice.

Not only are Coinbase's arguments weak, misguided and more akin to public relations than legal positions, but Coinbase's arguments are also proven failures of crypto-mumbo-jumbo and ludicrous jaundiced rhetoric.

Leading with their four typical talking points, Coinbase asserts: 1) The SEC approved our business and is now going back on their word; 2) We met with the SEC and the SEC would not work with us; 3) We need regulatory clarity because the SEC is stifling innovation; and 4) This is another instance of the destructive SEC practice of regulation by enforcement.

The SEC Did Not Approve Coinbase's Business Lines

Let's be clear: the SEC's role when "approving" Coinbase's registration statement was merely to ensure that Coinbase made the proper disclosures in their application.

To suggest that the SEC somehow endorsed or approved the various business lines of Coinbase (so Coinbase now has some sort of regulatory safe harbor for everything they do) has no basis in law or in fact.

Merely because two years ago?the SEC reviewed Coinbase’s registration statement (which Coinbase erroneously refers to as its "business plan") and approved Coinbase to go public is irrelevant. The same goes for any public company that has ever filed any registration statement with the SEC.

Along these lines, every prospectus or offering document provided to investors has to have what is known as the "SEC No Approval Clause" on the cover. The No Approval Clause states that the SEC neither approved or disapproved of the Securities offered herein. Nor dos the SEC make any representations on the accuracy or the adequacy of their information contained in the prospectus or offering document. The SEC essentially states, we looked at it, we have no opinion. The goal of review is to ensure that investors and potential investors have all the facts before buying a security, not that any business is legit.

The SEC staff reviews registration statements to see if the SEC’s disclosure rules are satisfied. The SEC does not evaluate the merits of securities offerings, or determine whether the securities offered are "good" investments or appropriate for a particular type of investor. Furthermore, the approval of a registration statement is not an SEC endorsement of its products or services or a statement that a registrant will lawfully operate its business.

The federal registration of securities offerings requires the issuer of the securities to disclose all material information relevant to an informed investment decision. Coinbase met the basic standards for disclosure in its registration statement which was filed, and approved by, the SEC.?

No sales of securities in a registered offering may occur until the Commission declares the registration statement effective. A registration statement typically becomes effective by order of the SEC. In declaring a registration statement effective under the Securities Act of 1933, the Commission does not consider the merits of the offering, but whether all material information is disclosed. In such reviews, the staff concentrates on disclosures that appear to conflict with SEC rules or the applicable accounting standards and on disclosure that appears to be materially deficient in explanation or clarity. The staff ’s review often results in revisions to the prospectus. However, the review process is not a guarantee that a company’s disclosure is complete or accurate.?

For example, if the SEC approves the registration of a drug company that offers a cure for heart disease, the SEC has not approved that the drug is safe. If the SEC approves the registration statement of an electric car company, the SEC has not approved that the cars produced are safe or that the brakes on the cars will function correctly.

UCLA law Professor Stephen Bainbridge neatly sums up the origins of the SEC review process as follows:

"Back in 1933, Congress considered three different models of securities regulation that states used in their blue sky laws:

--The merit model: Review by a state official of a proposed offering of securities to determine whether the deal included provisions that were “unfair, unjust, inequitable or oppressive” and whether it offered “a fair return.”

--The fraud model: Simply prohibit fraud in the sale of securities, with civil and/or criminal penalties for committing fraud.

--The disclosure model: Allow issuers to sell very risky or even unsound securities, provided they gave buyers enough information to make an informed investment decision.

In adopting the Securities Act of 1933, Congress opted for a mix of the latter two approaches. As a result, there is no merit review of whether investors will earn a decent return or the terms of the deal are fair. In theory, the act allows you to sell investors a rotten egg, as long as you tell them very clearly that the egg is rotten."

Finally, Coinbase's Form S1 Registration Statement under the Securities Act of 1933, the form that Coinbase filled out to become a public company and the form that the SEC reviewed, disclosed that there is regulatory uncertainty regarding the status of their activities” and that Coinbase could be subject to a litany of civil, criminal, and administrative fines, penalties, orders and actions (which is exactly what is happening right now).

In other words, Coinbase attested to the risks of their operations, stating unequivocally that: "A particular crypto asset’s status as a “security” in any relevant jurisdiction is subject to a high degree of uncertainty and if we are unable to properly characterize a crypto asset, we may be subject to regulatory scrutiny, investigations, fines, and other penalties, and our business, operating results, and financial condition may be adversely affected."

In fact, Coinbase's risk disclosure relating to the SEC Wells Notice is extensive and sprinkled throughout Coinbase's S1. Here's another example:

"Our business is subject to extensive laws, rules, regulations, policies, orders, determinations, directives, treaties, and legal and regulatory interpretations and guidance in the markets in which we operate, including those governing financial services and banking, trust companies, securities, broker-dealers and ATS, commodities, credit, crypto asset custody, exchange, and transfer, cross-border and domestic money and crypto asset transmission, consumer and commercial lending, usury, foreign currency exchange, privacy, data governance, data protection, cybersecurity, fraud detection, payment services (including payment processing and settlement services), consumer protection, escheatment, antitrust and competition, bankruptcy, tax, anti-bribery, economic and trade sanctions, anti-money laundering, and counter-terrorist financing. Many of these legal and regulatory regimes were adopted prior to the advent of the internet, mobile technologies, crypto assets, and related technologies. As a result, they do not contemplate or address unique issues associated with the cryptoeconomy, are subject to significant uncertainty, and vary widely across U.S. federal, state, and local and international jurisdictions. These legal and regulatory regimes, including the laws, rules, and regulations thereunder, evolve frequently and may be modified, interpreted, and applied in an inconsistent manner from one jurisdiction to another, and may conflict with one another. Moreover, the complexity and evolving nature of our business and the significant uncertainty surrounding the regulation of the cryptoeconomy requires us to exercise our judgement as to whether certain laws, rules, and regulations apply to us, and it is possible that governmental bodies and regulators may disagree with our conclusions. To the extent we have not complied with such laws, rules, and regulations, we could be subject to significant fines, revocation of licenses, limitations on our products and services, reputational harm, and other regulatory consequences."

The SEC Met With Coinbase -- So What?

We get it, Coinbase met with the SEC on multiple occasions -- but who cares, how is that at all relevant to anything??

These meetings between Coinbase and the SEC likely took place in two different settings. At the beginning, perhaps Coinbase approached the SEC to discuss its business and seek some sort of tacit approval or even an SEC staff no-action letter, which could somehow authorize Coinbase's operations.

Next, as the SEC has stated on numerous occasions since as early as 2017, the SEC regulatory staff probably told Coinbase that their operations raised serious issues of investor protection and potentially violated the U.S. federal securities laws.

When Coinbase defiantly continued their operations, the SEC Enforcement Division opened up an investigation and began to issue subpoenas to Coinbase’s employees and others to appear for testimony and to Coinbase to produce documents.

No matter what the context or SEC Division, Coinbase clearly did not like the responses they were receiving from the SEC regulatory staff and they did not respect the subpoenas they were receiving from the SEC enforcement staff -- and now Coinbase is crying foul. But, as SEC Chair Gary Gensler has stated time and again, "not liking the message isn’t the same thing as not receiving it."

Like so many other crypto-companies, Coinbase probably viewed the SEC subpoenas akin to census requests and failed to recognize their extraordinary gravitas. Following Gemini’s lead, Coinbase is now asserting the same absurd “SEC is super lame” defense recently uttered by Gemini after the SEC sued them.?

But being super lame is not a valid legal defense -- it is more akin to a whining and unfounded teenage cry of angst, dejection, malaise and protest.

There Already Exists Regulatory Clarity Relating to Crypto

Coinbase’s pivot to the tired and toothless refrain of berating the SEC for lacking regulatory clarity in its actions is farcical and a flat-out ruse. It’s like Elizabeth Holmes and Sonny Balwani blaming the FDA for bogus blood test results from Theranos’ counterfeit blood test machines.

Despite its pervasiveness and bluster, the Coinbase tagline calling for regulatory clarity is a noxious red herring and a complete disregard of management's fiduciary obligation to its shareholders.

Intended to sidetrack and dissemble the plain truth — that?crypto exchanges flagrantly violate bedrock principles of securities regulation?— the regulatory clarity and SEC hit-pieces are an impulsive and frantic attempt to appeal and co-opt fundamental notions of fairness, liberty and freedom (which most people cherish and hold dear).?

First off, securities regulation is not meant to be precise but is instead intentionally drafted to be broad and all-encompassing; clarity is not just uncommon, it is deliberately avoided.

Second, though securities regulation is primarily a principles-based legal framework, there already exists extraordinary regulatory transparency regarding crypto.

Finally, although the crypto industry constantly grouses for regulatory clarity, whenever any specific regulatory crypto-related rules are promulgated or proposed, the crypto industry cries foul and almost instantly files a flashy legal challenge to its enactment.

Per famed Supreme Court justice Thurgood Marshall:

"The fundamental purpose undergirding the Securities Acts is "to eliminate serious abuses in a largely unregulated securities market." United Housing Foundation, Inc. v. Forman,?421 U.S. 837, 849, 95 S.Ct. 2051, 2059, 44 L.Ed.2d 621 (1975). In defining the scope of the market that it wished to regulate, Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of "countless and variable schemes devised by those who seek the use of the money of others on the promise of profits," SEC v. W.J. Howey Co.,?328 U.S. 293, 299, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244 (1946), and determined that the best way to achieve its goal of protecting investors was "to define 'the term "security" in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.' " Forman, supra,?421 U.S., at 847-848, 95 S.Ct., at 2058-2059 (quoting H.R.Rep. No. 85, 73d Cong., 1st Sess., 11 (1933)). Congress therefore did not attempt precisely to cabin the scope of the Securities Acts.?Rather, it enacted a definition of "security" sufficiently broad to encompass virtually any instrument that might be sold as an investment."

Coinbase’s Cognitive Dissonance

Coinbase's plea for regulatory clarity and complaint that the SEC is stifling innovation are nothing more than distorted sophistical rhetoric and cacophonous cognitive dissonance.

It’s like arguing that banning asbestos means banning building construction, when in reality, just as asbestos asphyxiates and contaminates the lawful construction of buildings, crypto pollutes and suppresses benevolent technological transformation. Crypto regulation and transparency clears the way for legitimate technological innovation, progress, and development, rendering it free from abuse and criminal exploitation.

Crypto shills have for over a decade?promised how crypto will benefit U.S. citizens — by transforming the way U.S. businesses conduct financial transactions; by rendering U.S. use of energy, water, and any other raw material more efficient, more transparent, more reliable, and less costly; by verifying transactions instantaneously, eliminating significant costs, uncertainty and fraud; and by dramatically improving the way all U.S. citizens carry out our daily lives. But these ambitious prospects are nothing more than hi-tech boiler-room hype overflowing with distortion, flimflam and drivel.

In fact, Big Crypto consistently fails to reference?any?practical or tangible use of crypto that is not aspirational or cannot be accomplished more easily, more efficiently, more powerfully, and more safely by about a?bazillion?other digital means. With the exception of criminals, people do not use crypto for anything at all. Indeed, if anyone asked what problem in life crypto solves, no one can (honestly) name a single one. The Web3 industry is not just replete with bad apples, it’s rotten to the core.

To those crypto-shills screaming for regulatory clarity, trying to distinguish FTX from their wares and catalog, defending the cryptoverse, and deflecting the blame upon the SEC, please read the room.?Rome is burning. Now is not the time to point fingers at the SEC and denounce a mythical lack of regulatory clarity. Now is not the time to advocate to exonerate and excuse crypto-related greed, grift, irresponsibility and folly. Now is the time to preach the truth:

• That crypto?solves no societal problem and provides no tangible use?(other than speculation);
• That crypto?fails as a currency?because the price is too volatile; fees too high; taxes too burdensome; and risks too infinite;
• That crypto?fails as an investment?because there is no regulatory oversight, transparency, consumer protections, insurance, and the entire crypto rug-pull bazaar is so rife with market manipulation and insider trading and other fraud that investors stand no chance from the get-go;
• That crypto?has no intrinsic value?and is better described as a?2008 relic of computer code?of mind-numbing arithmetical blather whose sole characteristic seems to be that?another fool may be induced to pay more for it. In fact, calling the crypto-ecosystem a Ponzi scheme is not hyperbole —?it’s axiomatic;
• That a mere record on a glorified append-only, limited writer spreadsheet linked to the solution of a very complex yet entirely meaningless and irrelevant mathematical problem is not, and will never become, a?fiscal heal-all?or?financial inclusion panacea;
• That?the sole benefit of crypto flows to criminals?who use it to transact from anywhere and?secretly commit perilous crimes?like ransomware, murder-for-hire, terrorism, drug dealing, sanctions evasion, money laundering, human sex trafficking, child pornography, etc.;
• That the use of crypto?presents extraordinary challenges for law enforcement to trace and to recover, and requires immense resources, years of doggedness and lots of luck –?and prosecutorial success rarely happens; and
• That?it is easy to imagine a world without crypto?and if crypto disappeared tomorrow, nothing would change for anyone except criminals, who would lose their most effective felonious device and instantly suffer immeasurably.

Regulatory Clarity Ad Nauseam

Although SEC regulations are primarily principles-based and not proscriptive, that does not mean that the crypto marketplace lacks clarity of existing statutes, rules, and regulations. In fact, the reality is precisely the opposite.

With respect to digital tokens and digital assets, never in its history has the SEC taken such drastic measures to make its views known.?Along these lines, the SEC has used multiple distribution channels to share its message and concerns regarding crypto, digital trading platforms, initial coin offerings and other digital asset products and services.

For instance, with respect to crypto generally, the SEC has publicized its position through countless?enforcement actions, multiple?speeches,?a series of?Investor Alerts, a rare?Section 21(a) Report of Investigation,?staff guidance,?Congressional testimony, and several?official SEC statements?and?proclamations.

In fact, former SEC Chair Jay Clayton engaged in an unprecedented multi-year crypto-tour, always speaking bluntly and thoughtfully about the need for digital token offerings to be registered and addressing the many misconceptions in the digital asset marketplace.?Speaking at a legal gathering in January of 2018, Clayton even went so far as to admonish the lawyers counseling clients engaged in digital coin and token offerings and current SEC Chair Gary Gensler gave a very similar speech in late 2022?at the annual SEC Speaks?securities regulation conference.

After the Clayton era, SEC Chair Gary Gensler picked up right where Clayton left off, often speaking about the perils of?crypto lending?platforms and decentralized finance in his speeches,?warning?that their failure to register with the SEC may violate U.S. securities laws.?In fact, in an extraordinarily frank interview with Yahoo! Financial News, Gensler warned crypto exchanges that they are not just on his radar, but they have fallen squarely within his sights,?stating:

“The law is clear, it’s not about waving a wand. Congress spoke about this in 1934 . . . When a [digital] platform has securities on it, it is an exchange, and it’s a question of whether they’re registered or they’re operating outside of the law and I’ll leave it at that.”

In addition to all of the SEC’s crypto-related statements, regulatory pronouncements, etc., there are also tens of thousands of pages of comprehensive pleadings and fillings associated with the?130+ SEC crypto-related enforcement actions?and the SEC’s undefeated crypto-track record, which include five of the most notorious SEC crypto victories — Telegram, Kik, BlockFi, LBRY and the SEC’s 2021 Wells Notice of Coinbase (regarding its crypto-lending program).

To claim a lack of clarity and meaning amid such a concerted SEC effort for crypto-related transparency, notice, and candor seems not only disingenuous and ill-advised — but also seems part and parcel of an old-fashioned get-rich-quick scheme targeting the most vulnerable.

As Kelvin Low, Professor at Faculty of Law at the National University of Singapore, recently noted so eloquently:

"[F]inance was digital long before crypto was a thing. Digital does not equal crypto, which is eminently unsuitable for the masses with its obsession with immutability . . . what about the risks [of crypto] that have clearly presented themselves? All of them are risks we have seen before: in the securities market. Which is why they should be regulated as securities (regardless of whether your system defines them as such). Same risk, same regulation.?And quit it with the industry's nonsense about, "Clarity, not enforcement." What they mean is they want a clear set of rules with which to game the system so they don't have to comply with the regulations that protect the public from public offerings. Will this clarity be profitable? For the issuers, undoubtedly. For early investors or those who get discounts, probably. For later investors, expect history to repeat itself.We've already seen tragedy but it seems many are committed to seeing farce."

Big Crypto Hypocrisy

In every one of their lawsuits and public outcries, the?Big Crypto cartel?demands regulatory clarity, but whenever regulators actually deploy meaningful crypto-regulatory initiatives, the Big Crypto cartel does everything possible to strike down and cancel those initiatives.

Indeed, whenever any government law, rule, or regulation gets specific about crypto, crypto lobbying groups protest and file interminable lawsuits challenging the action. Consider the following five examples during the past few years involving Big Crypto’s challenges to:

1. The Infrastructure Investment and Jobs Act (“Infrastructure Act”);
2. SEC Rule 3b-16;
3. OFAC Sanctions Against Tornado Cash;
4. A Proposed Bitcoin Spot-ETF; and
5. FinCEN Anti Money Laundering (AML) Crypto-Rules.

The?origin of the saying?“Be careful what you wish for, because you just might get it” is not from?The Pussycat Dolls, but rather?Aesop’s Fables,?the notable collection of morality tales. But whatever the saying’s origin, it rings especially true for?companies like Coinbase?and the eternal quest for SEC crypto-related regulatory clarity. In his next speech, Chair Gensler should add a second and even more important message:?Be careful what you wish for Big Crypto, because you just might get it.

Regulation by Enforcement is a Bogus Big Crypto Catchphrase

Coinbase’s Regulation-by-Enforcement (RBE) talking point is nothing more than a bogus Big Crypto catchphrase and fails miserably as a defense.

Thankfully, Chair Gensler?refuses to buy into?such RBE nonsense. Chair Gensler has consistently stated (almost daily) that crypto companies are boldly disregarding fundamental securities laws. Along these lines, the SEC has filed over 130 crypto-related enforcement actions and never lost a single case. “Some market participants may call this regulation by enforcement,” Gensler?said?in a November 2022 speech, “I just call it enforcement.”

Some catchphrases are awesome like "May the Force Be With You." Some catchphrases are hilarious like, "More Cowbell." And some catchphrases are baseless and misleading like Theranos's mantra that, "One Tiny Drop Changes Everything." The catchphrase of "SEC Regulation by Enforcement," shouted from the rooftops by crypto-grifters, falls into that last category -- a complete and utter falsehood.

The crypto-spin goes as follows: The crypto-enforcement efforts of the SEC will crush innovation via?regulation-by-enforcement. Rather than create regulations that provide specificity and clarity to crypto-firms, the SEC instead unlawfully uses enforcement actions to develop the law on a case-by-case basis, molding securities regulation into whatever best suits the SEC staff at the time.

But litigation is precisely how securities regulation works. The flexibility of SEC statutory weaponry is an SEC hallmark, enabling SEC enforcement to keep fraud in check.

Securities regulation is rarely proscriptive but is a?principles-based?regulatory framework, much like other U.S. laws. For example, U.S. laws do not specify that one cannot steal a neighbor’s lawnmower from their garage, but rather prohibits the theft of someone else’s property, which covers all things, including lawnmowers. The same goes for securities regulation.

This is why the definitions of “security” in both?The Securities Act of 1933?and?The Securities Exchange Act of 1934?include not only conventional securities, such as “stocks” and “bonds” but also the more general term “investment contract.”?

The all-encompassing definition of investment contract was reinforced 76 years ago in the oft-cited Supreme Court case of?SEC v. Howey,?where the Court held that investment interests in orange groves constituted securities. Since then, courts have applied the?Howey Test?for decades, to investments in?eel farms?and?ostrich breeding?to?wholly bogus “prime bank notes.”

Take?so-called prime bank notes?for example, which were financial schemes that began to surface in the 1990s. Con artists shilled Prime bank notes as sound and safe financial instruments purporting to derive their value from secondary European markets for standby letters of credit. Prime bank notes, while appearing sophisticated and a safe investment bet, were actually a complete fiction.?

In the seminal prime bank case,?SEC v. Lauer, the purveyors of prime bank notes argued that prime bank notes were not securities because they were fictional; thus, the SEC lacked jurisdiction. The 7th Circuit disagreed, noting that the Howey Test did not require that the securities existed but rather whether the investment, if true, had the characteristics of an investment contract –– underscoring just how broad the definition of investment contract is.

The fact that securities laws on the books adapt well to technology should come as no surprise – they were drafted with that specific notion in mind. Consider a 1989 case captioned?Reves v. Ernst & Young,?where the Supreme Court stated:

“In defining the scope of the market that it wished to regulate,?Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of ‘countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

Per Reves and countless other precedent, judges have agreed that Congress never meant to "cabin the scope" of securities regulation but instead, crafted definitions to contemplate not only known securities arrangements at the time, but also any prospective instruments created by those who seek the use of others’ money on the promise of profits.

To prove their point, RBE proponents cite the many different types of crypto-offerings that the SEC has charged for failing to register their securities offerings with the SEC, without specifying them as such beforehand. But this argument fails on its face – and actually proves the opposite, i.e. that RBE is how SEC enforcement works.?

Indeed, courts have upheld a broad array of SEC cases involving?crypto-related offerings. In fact, in the?130+ crypto-related enforcement actions?already filed by the SEC, the SEC?has not lost a single case.?

Most recently, the RBE issue presented itself in an SEC case involving a?LBRY, Inc.,?a software firm that issued crypto asset securities called “LBRY Credits” or “LBC.” The SEC charged LBRY for selling unregistered securities but LBRY claimed it did not receive “fair notice” of the application of securities laws to the LBC offer/sale.?The decision is considered “a major blow” to crypto issuers, many of whom have argued to RBE promoters.?

In?LBRY, Inc., filed on March 29, 2022, the crypto-defense (and now war-cry) of “lack of regulatory clarity” and “regulation by enforcement” was specifically and unambiguously addressed – and summarily rejected.

Specifically, Judge Paul Barbadoro of New Hampshire federal court?granted the SEC’s summary judgment motion against LBRY.? LBRY had argued that the SEC’s attempt to treat LBC as a security violated its right to due process because the agency did not give LBRY fair notice that its offerings of LBC were subject to the securities laws. But LBRY lost.

In the first part of the ruling, the court held that LBRY offered/sold LBC as a security (LBRY had argued?that LBC functioned as a digital currency that is an essential component of the LBRY Blockchain). This part of the decision was unprecedented because it was the first time a judge had determined that a coin that was not distributed through an ICO, was a security. Also, in its final point on its Howey analysis, the court rejected LBRY’s argument that LBC could not be a security because it was a utility token with demonstrated purchases for consumptive, not investment, use.

The court noted that “[n]othing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract.” The court summarized its holding: “[w]hile some unknown number of purchasers may have acquired LBC in part for consumptive purposes, this does not change the fact that the objective economic realities of LBRY’s offerings of LBC establish that it was offering it as a security.”

In the second part of the ruling, the Court held?that LBRY did not have a defense that it lacked fair notice of the application of securities laws to the LBC offer/sale, resoundingly rejecting the so-called?Fair Notice?defense, which has become a critical page of the crypto-defense “regulatory clarity” playbook.?Judge Barbadoro stated:

“LBRY relies on the 2nd Circuit’s decision in Upton v. SEC for the proposition that the SEC may not impose a sanction for violating the securities laws ‘pursuant to a substantial change in its enforcement policy that was not reasonably communicated to the public.’ But the facts of Upton bear no resemblance to the present case.

Upton involved an attempt by the SEC to sanction the CFO of a brokerage firm for violating an SEC rule that established a formula for setting the amount of money that the brokerage was required to maintain in a customer reserve account. Although it was undisputed that the brokerage had at all times complied with the “literal terms” of the rule, an ALJ relied on a novel interpretation of the rule by the SEC to conclude that the CFO could be sanctioned. Because the SEC did not give public notice of its new interpretation until after the brokerage had ended its offensive practice, the Second Circuit vacated the sanction imposed by the Commission. The present case is obviously quite different from the problem the court confronted in Upton.

The SEC has not based its enforcement action here on a novel interpretation of a rule that by its terms does not expressly prohibit the relevant conduct. Instead, the SEC has based its claim on a straightforward application of a venerable Supreme Court precedent that has been applied by hundreds of federal courts across the country over more than 70 years . . . ”

As some experts have?now explained, in rejecting LBRY’s contention that the SEC’s suit constituted a “substantial change in its enforcement policy that was not reasonably communicated to the public” because LBRY did not conduct an ICO, “the court held that the SEC’s theory fit comfortably within the bounds of prior caselaw.” The Court noted specifically that LBRY had no basis for asserting it was unaware of Howey’s guidelines, even if it sold LBC tokens in a non-ICO context.

The bottom line for all crypto-investment iterations? Whether an investment product acts as a stock token, is priced off of the value of securities and operates like derivative, is a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities, they must all comply with U.S. securities laws.

As Chair Gensler?recently explained:

“It’s not about whether you set up a legal entity as a nonprofit and funded it with tokens. It’s not whether you rely on open-source software or can use a token within some smart contract. These are not laundromat tokens: Promoters are marketing and the investing public is buying most of these tokens, touting or anticipating profits based on the efforts of others.“

Specifically Lacking Specificity

From?policing foreign bribery payments?(before the?Foreign Corrupt Practices Act), to?municipal securities fraud, to?derivatives scams?and?unlawful insider trading, to?fictional prime bank instruments?and?subprime grifts, to non-existent?eel farms?and bogus?ostrich farms, the SEC has addressed emerging issues via enforcement actions, and without the benefit, or the hindrance, of precise prescriptions.

Instead, whatever the technologies or innovations involved, the SEC has relied on the general principles of the federal securities laws and applied them with practicality and prudence. Merely because no blackletter rule exists does not somehow violate due process or?render the SEC’s enforcement efforts into ex post facto punishment.

Even before the Howey Test, in the first several years of U.S. federal securities laws,?some entrepreneurs were notified?that they had to register their offerings of chinchillas, whiskey warehouse receipts, oyster beds and live silver foxes as securities offerings.

Along these lines, the?SEC?prevented?Coinbase?from launching, and?stopped BlockFi?from operating (also fining them $100M) their crypto-lending programs.?The SEC also??filed an unprecedented emergency action?to stop Telegram’s?crypto-SAFT (Simple Agreement for Future Tokens) IPO, forcing Telegram to return $1.2B to investors.?The SEC has also?steadfastly refused?(despite extraordinary political pressure) to allow any U.S. firm to offer bitcoin spot ETF's to investors.??

With every new hi-tech advancement, those whose behavior was questioned have quipped: “Why didn't the SEC tell us that this behavior is illegal?” Like Coinbase, these companies argue that if there is no blackletter rule, the government’s efforts amount to RBE, reflecting a misguided or even nefarious bureaucratic proclivity to?expand power and broaden jurisdiction.

But the SEC’s approach is rarely improperly expansive, nor does it involve rogue SEC enforcement efforts. Rather, the SEC typically adopts a reasoned, common sense application of the basic requirements of the federal securities laws to?new and evolving market conditions and technologies.

The same goes for SEC enforcement efforts relating to crypto and all the rest of the increasingly dangerous Web3 variants, many of which threaten not just individual investors but all global capital markets.

Regulatory Misappropriation/Crypto-Marketing Theater

It remains unclear which particular securities law violations the SEC will charge Coinbase and the SEC could opt not to charge Coinbase with any securities violations at all. But an SEC enforcement action against Coinbase seems likely and the charges could be myriad.

By calling themselves “exchanges,” “brokers,” and “market-makers.” Crypto trading platforms co-opt historically powerful nomenclature that implies trust, oversight and consumer protection, etc., which can quickly evolve into dangerous and unlawful marketing theater.?

It’s like if a drug dealer suddenly offered to perform brain surgery for their customers, yet had never gone to college or medical school, never done a hospital internship or residency and their only health training consisted of watching a few TikTok videos on how to sell heroin to elementary school kids.

The stark reality is that by hijacking bona-fide regulatory labels, together with a sleek website, flashy Super Bowl commercials and attractive customer-interphase, entities like Coinbase create a counterfeit veneer of assurances, integrity, expertise and regulatory supervision.?

The SEC became so concerned about this arguably unlawful nomenclature that they took the unusual step of issuing an?official statement?to address the misinformation, stating on March 18th, 2018:?

“Many platforms refer to themselves as "exchanges," which can give the misimpression to investors that they are regulated or meet the regulatory standards of a national securities exchange.?Although some of these platforms claim to use strict standards to pick only high-quality digital assets to trade, the SEC does not review these standards or the digital assets that the platforms select, and the so-called standards should not be equated to the listing standards of national securities exchanges.?Likewise, the SEC does not review the trading protocols used by these platforms, which determine how orders interact and execute, and access to a platform's trading services may not be the same for all users.?Again, investors should not assume the trading protocols meet the standards of an SEC-registered national securities exchange.?Lastly, many of these platforms give the impression that they perform exchange-like functions by offering order books with updated bid and ask pricing and data about executions on the system, but there is no reason to believe that such information has the same integrity as that provided by national securities exchanges.”

In addition, the term “regulated” has similarly been misappropriated and causes tremendous confusion, especially when used as a tool to convince customers that their investment is a lot safer than it actually is.?For example, Coinbase often touts that they are a “regulated” firm, but to me, they are not, at least not in the true sense of the word.?

Yes, Coinbase is a publicly traded company and files quarterly reports with the SEC about their operations, as well as an annual report which must contain audited financial statements. Coinbase can get into SEC trouble if any of the statements, representations are misleading (by act or omission) and all information must represent a fair and accurate depiction of Coinbase’s financial condition.?

Granted, being an SEC publicly registered company is a big deal and a legitimate differentiator for Coinbase. And being an SEC-registered public company does imply some degree of oversight, at least relating to public disclosures, insider trading of its stock, and other SEC requirements. But being an?SEC-registered public company?is a far cry from being an actual?SEC-registered financial firm.

What SEC Regulation Actually Means

Regulatory frameworks come in all shapes and sizes and are not all equally robust, vigorous and effective.?For instance, there exist regulatory frameworks designed to ensure that dog poop is cleaned up by dog owners and to ensure that only those individuals with the proper level of experience, training and competence can fly commercial airplanes or perform heart surgery. The same variations apply to financial frameworks.?

U.S. SEC registration of financial firms: (1) mandates that investor funds and securities be handled appropriately; (2) ensures that investors understand the risks involved in purchasing the often illiquid and speculative securities that are traded on a cryptocurrency platform; (3) makes buyers aware of the last prices on securities traded over a cryptocurrency platform; and (4) provides adequate disclosures regarding their trading policies, practices and procedures. Overall, entities providing financial services must carefully handle access to, and control of, investor funds, and provide all users with adequate protection and fortification.

With traditional SEC-registered financial firms, the SEC has absolute, unlimited and?instantaneous visibility into every aspect of?operations. With crypto trading platforms, the SEC lacks?any sort of oversight and access?—?and has scant ability to surveil transactions, to detect suspicious activity and to investigate and deter?fraudulent conduct in real-time.?As a result, the crypto marketplace?—?like all Web3 marketplaces?—?operates without much supervision, lacking:

1. The hallmarks of the traditional transparent surveillance program of a financial firm?like an SEC-registered broker-dealer or?investment adviser, so the SEC cannot?analyze or verify market trading and clearing activity, customer identities and other?critical data for risk and fraud;
2. SEC and/or Financial Industry Regulatory Authority licensure of individuals?involved in crypto trading, operation,?promotion, etc., so the SEC cannot detect?individual misconduct and enforce violations;
3. Traditional accountability structures and fiduciaries of financial firms, so the SEC?cannot ensure that every customer's?interest is protected and held sacrosanct;
4. The compliance systems, personnel and infrastructure, so the SEC cannot know?where crypto came from or who holds most of?it; and
5. The verification and investigatory routine and for cause SEC or FINRA examinations,?inspections and audits, so the SEC and?FINRA cannot patrol, supervise or verify?critical customer protections and compliance mechanisms.

Registering with FinCEN, with New York State as a “Trust,”?with a non-U.S. regulator, even with all of the 50 states as a “money service business” are meaningful achievements – but are all a far cry from U.S. SEC registration. There’s a reason why there are only?16 SEC-registered “exchanges” --??the oversight is akin to experiencing a permanent financial and operational colonoscopy, 24-hours a day, 365 days a year.

In other words, just because I clean up my dog’s poop when taking her on a walk (even when no one is watching), does not make me “regulated” enough that anyone should trust me to fly an airplane or perform heart surgery.

Looking Ahead

I am no SEC shill and have not hesitated to criticize (loudly) the SEC over the years. For example, consider my scathing criticisms of the?SEC's recent enforcement action against Covington & Burling; my unmerciful attack on the?recent surge of SEC cybersecurity enforcement actions; my ardent opposition to the?SEC's recent proposed cyber-attack disclosure rules; my steadfast view of the?SEC's consistent neglect of the privacy of SEC witnesses; and and my consistent condemnation of SEC administrative judicial procedures, which are, IMHO, sometimes clearly unconstitutional.?

But the SEC's crypto-mission is spot-on and the SEC staff's case against Coinbase will likely be rock-solid, just like the 130+ previous SEC crypto-related SEC enforcement actions. For any crypto-company doing business in the U.S., the SEC can asphyxiate their operations forthwith by applying its existing robust arsenal of broad statutory weaponry to all crypto-trading firms and facilitators operating in the U.S., including filing enforcement actions for failing to register as 1) an "exchange;" 2) a "broker-dealer;" 3) a "market-maker" or 4) an "investment company."

The SEC need not even charge actions relating to specific "exchange-related" activities but instead could opt to focus on crypto-services. For instance, consider the interesting part of the SEC Wells Notice relating to Coinbase's digital wallet services.

In addition to online trading platforms, the?SEC's March 7, 2018 Statement on Potentially Unlawful Online Platforms for Trading Digital Assets?also raised concerns about companies that offer “digital wallet services” for holding or storing digital assets:?

“Some online trading platforms may not meet the definition of an exchange under the federal securities laws, but directly or indirectly offer trading or other services related to digital assets that are securities.?For example, some platforms offer digital wallet services (to hold or store digital assets) or transact in digital assets that are securities.??These and other services offered by platforms may trigger other registration requirements under the federal securities laws, including broker-dealer, transfer agent, or clearing agency registration, among other things.”

Along these lines, in a?July 8, 2019 Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities, the SEC and FINRA clarified that entities seeking to participate in the marketplace for digital asset securities must comply with the relevant securities laws, most notably the customer protection rule. The SEC warned that non-registered firms would likely have to register as a broker-dealer before engaging in custodian services related to digital asset securities, noting that:

“The requirements of the Customer Protection Rule have produced a nearly fifty year track record of recovery for investors when their broker-dealers have failed . . . This record of protecting customer assets held in custody by broker-dealers stands in contrast to recent reports of cybertheft, and underscores the need to ensure broker-dealers robust protection of customer assets, including digital asset securities.”

Digital wallets have become a common custodial service offered by an array of crypto intermediaries. By targeting digital wallet services (such as the digital wallet services provided by Coinbase) for SEC registration violations, the SEC could significantly impact the crypto marketplace, potentially crippling an important access point of crypto users.

Like every other crypto-firm, Coinbase fights the SEC every minute of every day and loses every time. For crypto-firms, my take is fail not at your peril, because Big Crypto's regulatory losing streak, be it relating to Coinbase or any other crypto-firm, is likely to continue ad infinitum.

*John Reed Stark?is president of?John?Reed Stark Consulting LLC, a data breach response and digital compliance firm. Formerly, Mr. Stark served for almost 20 years in the Enforcement Division of the U.S. Securities and Exchange Commission, the last?11 of which?as Chief of its Office of Internet Enforcement. He currently teaches a?cyber-law course?as a Senior Lecturing Fellow at Duke University Law School.?Mr. Stark also worked?for 15 years as an Adjunct Professor of Law at the Georgetown University Law Center, where he taught several courses on the juxtaposition of law, technology, and crime, and for five years as managing director of global data breach response firm, Stroz Friedberg, including three years heading its Washington, D.C. office. Mr. Stark is the author of “The Cybersecurity Due Diligence Handbook.”