Page 181: A Comprehensive Review of Coinbase Legal Documents: Strong Response to SEC Lawsuit and Seeking to Dismiss the Case

Coinbase's Response to SEC Lawsuit and Attempt to Dismiss Case: Comprehensive Review on Page 181.

Cryptocurrency exchange Coinbase has submitted a response and a motion to dismiss to the US Securities and Exchange Commission’s (SEC) lawsuit, responding to the regulator’s allegations of illegal operation of an unregistered securities exchange. In this response, Coinbase maintains that the SEC’s allegations lack merit and emphasizes that it underwent a thorough review of its business practices by the SEC prior to going public. Coinbase’s Chief Legal Officer, Paul Grewal, stated that the company never listed securities and that their process for token listings was exactly the same as the SEC’s scrutiny in early 2021. This defense filing marks Coinbase’s formal response to the legal dispute, signaling a long legal battle ahead.

So what did Coinbase actually say in these two legal documents? How did it argue that the tokens traded on its platform are not securities? This article summarizes the main contents of the two documents.

Coinbase’s Motion to Dismiss

This motion was directly submitted to the presiding judge by Coinbase and seeks to dismiss the case outright. Briefly introducing the SEC’s core allegations against Coinbase and its four targets: that Coinbase engaged in spot and institutional trading, securities brokerage, wallet custody, and staking services, the filing goes straight to the crux of this case, that is, whether cryptocurrencies and staking services should be considered “securities” for the purpose of determining whether Coinbase has violated the law. In the filing, Coinbase sums it up succinctly: “They (referring to cryptocurrencies and assets) are not securities. Therefore, this case should be dismissed.”

On the specific logical argumentation, Coinbase systematically refutes the SEC’s allegations based on the Howey test (the case that formed the Howey test).

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It first points out that under the definition of the US Securities Act and Securities Law, the term “security” includes “any instrument commonly known as a ‘security’,” one of which is an “investment contract.” This concept was established in the Howey case 77 years ago, which defined an “investment contract” as “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” However, the transactions on the Coinbase platform and Prime services are not this type of contract, but asset sales, where the obligations of both parties are fulfilled when digital tokens are delivered in exchange for money. Unlike stocks and other securities, when these tokens are traded on Coinbase, there are no statutory or contractual rights (such as dividends) associated with them. Any purchaser on Coinbase cannot claim more than the right to acquire the tokens. Without such a continuing contractual relationship, the SEC’s allegations cannot stand.

In addition, regardless of any extra-contractual expectations Coinbase’s purchasers may have had regarding appreciation in the value of its tokens, that alone does not give rise to a contractual relationship governing a profit-seeking enterprise, especially where the business plan and implementation are not solely reliant on the efforts of others. Classic securities can be simple stock, representing an ownership interest in dividends and residual corporate value; preferred stock, with interest and liquidation preferences; bonds, notes, or other debt agreements, providing fixed returns to investors; or investment contracts, where investors pay funds in exchange for a contractual right to participate in the enterprise’s earnings. But a necessary ingredient is the existence of a legally enforceable right in the enterprise. Because transactions on Coinbase do not involve such a right, they are not securities.

Even if the SEC were to articulate a credible theory that the transactions at issue here were “investment contracts,” the “Howey test” would nonetheless require dismissal of the Complaint. Because Congress has clearly recognised that it has not delegated authority to regulate cryptocurrencies and is actively considering the regulatory structure, the SEC lacks authority to exercise “clear Congressional authorisation” over this trillion-dollar emerging industry.

Similarly, attacks on Coinbase’s wallet and staking services do not hold up. The SEC has failed to charge that the tokens available in the wallet have the key features of an investment contract, nor has it identified wallet functionality as that of a “broker” under the securities laws. As to staking functionality, because the facts alleged in the Complaint indicate that customers staking through Coinbase’s software neither obtain an ownership interest in the enterprise through investment of funds nor face risk of loss by staking their tokens, and instead receive administrative, as opposed to managerial, services, there is no investment contract as a matter of law.

This filing gained attention on Twitter, with Coinbase’s Chief Legal Officer, Paul Grewal, retweeting it himself.

Coinbase’s 177-page response to the SEC’s case allegations

In this 177-page response, Coinbase refutes (or partially admits to) all of the allegations in the SEC’s complaint, and further presents all of the arguments and evidence as to why the SEC’s claims do not hold water.

Argument 1: Full SEC review when Coinbase went public in 2021, but no objections were raised then

According to the filing, when Coinbase sought to go public in April 2021, the U.S. Securities and Exchange Commission announced that Coinbase’s registration statement was effective, allowing Coinbase’s stock to be sold to millions of retail and institutional investors. This announcement came after “months of discussion with Coinbase and extensive review and comment on Coinbase’s registration statement.” Coinbase opened up its business to the SEC, explaining its core businesses such as listing, trading, and staking of digital assets, as well as its self-custody wallet software, which was and is a core aspect of Coinbase’s operation. Based on its mission to consider “the public interest and investor protection,” the SEC allowed Coinbase to go public and never suggested that Coinbase needed to register its business.

Argument 6: SEC needs formal rule-making procedures even if it has regulatory power, not just a lawsuit

Coinbase asserts that even if the SEC has necessary legal authority, the institution’s new interpretation of “investment contracts” requires formal rule-making procedures. Declaring so-called regulatory power through punitive enforcement actions instead of regulatory procedures with notification and solicitation of opinions is a violation of due process and an abuse of power by the institution, which is enough to reject the claimed right.In the face of the SEC’s improper claims of power to fill existing regulatory gaps, the federal court has acknowledged the confusion the SEC brings to market participants. As a court recently observed, “The regulatory agency itself seems unable to agree on whether cryptocurrency is a commodity subject to CFTC regulation, a security subject to securities laws, or neither, or even what standards should be applied to make that determination.” As another court recently asked, “Why is it wise for the Committee to leave a decision that will have such far-reaching effects in an industry worth billions of dollars to a single federal district judge?”Coinbase writes in the subsequent section that the SEC chooses to push its aggressive agenda through punitive retroactive enforcement actions instead of testing its new views through notice and comment rule-making. The institution’s power of enforcement is important, but not unlimited. The SEC’s actions here exceeded those limits and should be recognized as illegal.

Argument 7: The SEC did not provide any explanation or opportunity for cooperation with Coinbase and chose to sue directly

Coinbase illustrates this point with an example. On the same day Coinbase submitted its application, the SEC sued a former Coinbase employee, 32, and his brother – the SEC v. Wahi case – for using Coinbase’s confidential information to make early purchases of nine tokens on the Coinbase platform on the basis of “securities” fraud. The US Department of Justice did not claim that these tokens were securities in its parallel action. But the SEC did, and the lawsuit did not mention Coinbase or any issuer or developer of the tokens involved.Therefore, the interaction between the SEC and Coinbase was not through any regulatory procedure, but through proxy lawsuits, leaving Coinbase’s asset listing decisions, extensive compliance efforts, and years of interaction with the SEC to be defended by unprepared, unsympathetic criminals (referring to Wahi), who harmed the company. Faced with the defendant’s motion to dismiss and documents submitted by Coinbase and other friend-of-the-court parties with detailed supporting documents, revealing that the lawsuit exceeded the SEC’s statutory authority and violated due process (the basic defects raised by Coinbase in this case again), the SEC summarily terminated the Wahi lawsuit in a settlement without admission or denial of liability. This part implies that the SEC tried to prove that the tokens traded on Coinbase were securities through another completely unrelated case, without giving Coinbase any opportunity to explain.

Coinbase believes that the SEC’s enforcement approach is “retrospective responsibility” rather than “forward-looking guidance,” which has led to a series of other enforcement actions. As these actions increase, SEC Commissioner Hester Pierce pointed out that “using enforcement actions to tell people what the law is in emerging industries is unfair,” and she observed that “one-time enforcement actions and cookie-cutter analyses don’t work.”

Argument 8: Gary Gensler’s Contradictory Remarks

In December 2022, Chairman Gensler told a reporter that he believes the SEC has enough power to fully regulate digital asset platforms. This is directly contrary to Chairman Gensler’s previous admission that Congress has not authorized the SEC to regulate digital platforms. And during this 18-month period, there has been no change in the law. However, Mr. Gensler announced that digital asset platforms can and must come forward and register with us immediately. But Coinbase has already met with the SEC dozens of times and has applied to the SEC through rulemaking precisely because there are currently no existing rules to regulate the registration of digital asset securities and digital asset exchanges. The SEC itself has claimed that “the trading venues regulated by the SEC involve only securities.” As some senior SEC officials have acknowledged, Bitcoin and Ethereum are commodities, not securities, so exchanges that trade both commodities and securities cannot be registered. This is also one of the reasons why Coinbase’s listing process is designed to avoid listing assets that the SEC may designate as securities based on its previous statements.

Argument 9: Coinbase Has Always Hoped to Cooperate, but Has Been Repeatedly Rejected by the SEC

According to Coinbase, in late 2022 and early 2023, Coinbase continued to work with the SEC. In more than a dozen demos and more than 27 phone calls, Coinbase shared with the SEC its views on the possible structure of a registered digital asset securities trading platform and the feasibility of trading securities and non-securities on a single platform. On the day before the planned meeting, which was originally intended for SEC staff to provide the first substantive response to Coinbase, the staff cancelled the meeting and informed Coinbase that they would instead take enforcement action.

On March 22, 2023, SEC staff issued a Wells notice informing Coinbase staff that they intended to recommend to the Commission that enforcement action be taken against the company. The Wells notice was issued while Coinbase was still providing documents to the SEC and after staff had taken testimony from only two mid-level Coinbase employees. The SEC did not disclose its specific charges against Coinbase. Coinbase asked directly in the Wells notice conference call: which assets traded on our platform are securities? The staff said they “had no way” to determine which specific assets.

Argument 10: SEC’s injunction application in the previous Third Circuit Court was ambiguous

In the injunction (requesting SEC to provide specific explanations regarding the allegations) application filed by SEC in the Third Circuit Court before Coinbase, SEC’s statements before and after the application were completely contradictory. Coinbase claimed that the injunction application was made under the background of “facing imminent law enforcement action, with uncertain scope and timing, and SEC has not yet made a decision on the company’s nine-month rule-making petition, let alone provide any formal guidance on the basis of the agency’s new regulatory expansion”.

Coinbase requested that the Third Circuit Appeals Court order SEC “to explain on the record whether it will initiate proceedings to establish rules against others and potentially soon against Coinbase”. The reason for seeking help is clear: SEC is enforcing new digital asset regulatory standards that have never been publicly disclosed before, and these standards contradict SEC officials’ previous statements and Coinbase’s DPO process. As part of the appropriate administrative procedures and due process, Coinbase has the right to know the basis for SEC’s claim of its newly discovered broad authority, or challenge SEC in court if it refuses to provide it.

In response to the injunction petition, SEC was hesitant on May 15, 2023. It claimed that it did not have a “secret decision to reject” Coinbase’s petition. SEC told the court that Coinbase’s proposal was “unfounded”. But in a public speech on the same day, Chairman Gensler expressed the opposite view that no additional guidance was needed as the rule had already been published.

Coinbase’s legal response to SEC’s lawsuit detailed the company’s position and viewpoint, claiming that it had undergone a comprehensive review by SEC before going public, complied with legal requirements and followed business norms. This legal dispute will continue and may evolve into a long-term struggle. The debate between the two sides will determine the boundaries of rights and responsibilities between the cryptocurrency exchange industry and regulatory agencies and the future development direction.

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