Coinbase Court Embraces ‘Ecosystem’ Approach to Identifying Crypto-Asset Securities

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.

^{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.}