Coinbase Vs. SEC: New Filings And A Heated Preliminary Hearing

Summary Coinbase stock surged 24% on July 13 after a U.S. District Court judge ruled in favor of Ripple's sale of XRP on secondary marketplaces. While investor focus was fixed on regulatory developments surrounding XRP, Coinbase went to court yesterday for the first preliminary hearing in the case between the SEC and Coinbase. In a 177-page court document dated June 28, Coinbase made several arguments to dismiss the SEC’s allegations, and I present a few of these major arguments in this article. The SEC, on July 7, filed a response to these arguments raised by Coinbase. Yesterday's preliminary hearing lasted two hours, revealing the direction of the upcoming battle in court. Coinbase Global, Inc. ( COIN ) shares surged more than 24% on July 13 after a U.S. District Court judge ruled that Ripple Lab’s (XRP-USD) sales of XRP - a cryptocurrency – to the public cannot be recognized as a sale of securities, meaning crypto exchanges that provided retail investors with access to trading XRP will not be found guilty of selling securities without registration. Soon after this decision was made public, Coinbase announced that it will re-enable trading for XRP on the XRP network. This court ruling came after the Securities and Exchange Commission sued Ripple Labs in December 2020 alleging that the company raised $1.3 billion through the sale of unregistered digital assets, including XRP. Yesterday’s court decision sent cryptocurrency prices higher, with Bitcoin and Ethereum gaining 4.2% and 6.6%, respectively. The positive market reaction has pushed Coinbase stock to the fairly valued territory, and investors will have to be cautious going forward as some of the company's risks do not seem to be baked into the current market price. While investor focus was fixed on regulatory developments surrounding XRP, Coinbase went to court yesterday for the first preliminary hearing in the case between the SEC and Coinbase. Recent filings and yesterday’s pre-hearing reveal new details about the legal battle between the watchdog and the nation’s largest cryptocurrency platform. New Details Emerge As Coinbase Readies To Defend Itself On June 6, the SEC sued Coinbase alleging that the company sold 13 unregistered securities to retail investors. Coinbase, in return, pledged to defend its business practices in court, saying that its sale of cryptocurrencies does not require registration with the SEC as this process cannot be categorized as a sale of securities. The surge in Coinbase stock on July 13 is understandable given that the recent court ruling in favor of XRP establishes that allowing retail investors to access cryptocurrencies on an exchange marketplace does not constitute a sale of securities. The District judge, however, ruled that Ripple’s institutional sales of XRP were securities contracts as these professional investors knew they were contributing capital to Ripple, although retail investors had no way of knowing whether they were buying XRP from another retail investor or from the company itself. Since Coinbase acts as a marketplace, the company is likely to use this ruling in future court hearings to establish that it did not engage in unregistered securities sales. Overall, this is a positive outcome, but it would be naïve to think the company is out of the woods. Recent filings and court documents show the intensifying battle between the SEC and Coinbase. The watchdog is very likely to come hard at Coinbase to establish its relevance amid the growing importance of digital assets, given that Coinbase argues SEC does not have sufficient jurisdiction to sue the company for allegedly selling unregistered securities to the public. A lot has already been said and written about SEC’s original allegations, so let’s start with Coinbase’s response to these allegations. In a court document dated June 28, Coinbase made several arguments to dismiss the SEC’s allegations. Some of the key arguments from this 177-page document are highlighted below. Coinbase is not a securities exchange or broker but a secondary marketplace. The SEC’s acceptance and approval of Coinbase’s registration statement in 2021 without once suggesting Coinbase must register its operations is contradictory to its recent claims. Six of the 12 crypto tokens that are now being targeted by the SEC claiming they are securities have been on Coinbase’s marketplace even at the time the SEC approved its registration statement. In May 2021, SEC chair Gary Gensler testified before Congress, claiming that the SEC did not have statutory authority to regulate crypto trading and businesses like Coinbase. According to the definitions outlined in the Taft Administration, assets traded on the Coinbase platform cannot be classified as investment contracts. The SEC has expanded its definition of investment contracts in the recent past without a congressional mandate. Going by these arguments, it is evident that Coinbase will defend its case with two major arguments. The company is not involved in primary market activities and therefore cannot be alleged of selling investment contracts and securities. The SEC does not have jurisdiction to regulate digital assets. Things get more heated from here on. The SEC, on July 7, filed a response to these arguments raised by Coinbase. In this 4-page document, the SEC suggests that its approval of Coinbase’s registration statement in 2021 was based on the facts at that time, which may have changed now. Also, the SEC claims that Coinbase discouraged crypto asset issuers from using certain statements that may attract regulatory troubles. The SEC goes on to argue that Coinbase’s definition of an investment contract is flawed. The below excerpt from the SEC’s response to Coinbase sets the tone for the watchdog’s counterargument. Ignoring more than 75 years of controlling law under Howey, Coinbase attempts to construct its own test for what constitutes an investment contract from pre-1933 Blue Sky laws based on common law contracts principles. Coinbase makes two related and equally flawed arguments: (1) an investment contract must be or include a formal, common law contract; and (2) even if a crypto asset is considered an investment contract when it is first offered and sold by an issuer, that same asset cannot be an investment contract when traded between non-issuers on a platform like Coinbase’s because secondary market transactions not involving its issuer are merely “asset sales.” Both arguments are wrong. Now we come to yesterday’s events. No, I’m not talking about the court ruling on XRP anymore. While investor focus was fixed on the events surrounding XRP, Coinbase and the SEC faced off in a preliminary hearing yesterday that lasted two hours. Judge Katherine Polk Faila questioned both parties on various subjects including the definition of an investment contract, the nature of a security, and Coinbase’s staking business. Coinbase reportedly asserted the Major Questions Doctrine and requested the judge to dismiss the case, citing that the SEC does not have jurisdiction over the regulation of digital assets. The Major Questions Doctrine dictates that to decide an issue of major national significance, the action of a court must be supported by clear congressional authorization. According to Axios, Coinbase legal counsel and former co-director of the SEC’s enforcement division Steven Peikin questioned the SEC’s stance by highlighting a speech by former SEC director Bill Hinman in 2018 in which he claimed both Bitcoin and Ethereum were not securities. Takeaway The battle between Coinbase and the SEC is certainly heating up. Although yesterday’s court ruling on XRP paves the way for Coinbase to strengthen its case using it as an example, I believe the company will come under pressure during the court hearing. Although not a legal expert, I also believe Coinbase will be able to come up with a strong defense, which should ultimately help the company shake off regulatory pressures and thrive in the long term. As I have highlighted in many of my previous articles, I believe Coinbase is well-positioned to grow exponentially in the long term, and I prefer investing in Coinbase over any other crypto asset to gain exposure to the crypto sector. That being said, I am wary of investing in Coinbase today, given my belief that a lot of positive news has already been factored into the market price. In contrast, the risk of falling crypto trade volumes, the threat to the company’s staking business and thereby diversification efforts, and growing regulatory troubles are yet to be fully reflected in the current valuation. This calls for investors to be cautious of investing in Coinbase stock today.