George Leonardo
Good morning. This week, we cover a Congressional push for clarity on Ether's regulatory status and an eventful week in the courts.
Republicans on key House committees are asking SEC Chair Gensler to state definitively whether the SEC believes Ether is a security or not by April 9th.
SDNY Judge Failla allows SEC's case against Coinbase to go forward, largely agreeing with the SEC's interpretation of what constitutes an investment contract, but in a boon to self-custody and DeFi, dismisses SEC's claim that Coinbase Wallet is a broker.
On Tuesday, House Financial Services Chairman Patrick McHenry (R-NC) and House Ag Chairman Glenn Thompson (R-PA) led committee Republicans in a letter to Chair Gensler urging the SEC to clarify its position regarding whether Ether ("ETH") is a security or not.
48 Republican Members signed the Letter.
Background
Earlier this year, Prometheum Capital, a FINRA approved special purpose broker-dealer ("SPBD"), announced it would begin custodying ETH for institutional clients.
But according to guidance previously published by the SEC, SPBDs are only authorized to custody digital assets that are securities. See Letter at 2 (citing 86 Fed. Reg. 11,627, 11,629 (Feb. 26, 2021)).
The SEC and CFTC have previously recognized that ETH is not a digital asset security. For example, in October 2023, the SEC approved nine exchange traded funds providing exposure to ETH commodity futures products.
The Letter
Against this backdrop, Members want clarification on two main points:
Does the SEC now think ETH is a security? If so, how and when did it reach that determination?
How did Prometheum determine it can custody ETH without running afoul of the SEC’s SPBD rules?
Key Concerns
At a high-level, Members are concerned with the SEC's overall lack of transparency and clarity regarding Prometheum's intent to custody ETH. Letter at 1.
Further, they are concerned that an SEC determination that ETH is a security would have key implications for the futures markets. For example, CFTC-registered exchanges may no longer be able to list and offer ETH futures for trading. Letter at 4. In turn, this would:
deprive market participants of an essential risk management tool,
imperil existing SEC-approved ETH futures ETFs,
result in "significant price dislocation across the ETH market," and
potentially place CFTC registered exchanges listing ETH futures products in violation of securities laws. Id.
Questions & Explanations
Here's a closer look at some of the specific questions and information requests included in the Letter:
Is ETH a digital asset security?
If it is a security, Members want a comprehensive explanation for how and when the SEC reached that determination.
If it's not a security, they want to know whether the SEC will prohibit Prometheum from providing custody for ETH.
If the SEC will allow Prometheum to custody ETH, they want to know why it would allow an SPBD to contravene the agency's previous guidance.
Members also want:
A description of various terms the SEC uses to describe digital assets and how they are different:
Terms include: crypto tokens, crypto security tokens, crypto assets, crypto asset securities, digital asset securities, and digital asset securities that are investment contracts.
A description of the SEC's discussions with the CFTC on digital asset issues.
See full list of requests on pages 4-6.
The Members want a response by April 9, 2024.
TLDR: The court sided with the SEC in holding the Major Questions Doctrine does not bar the SEC's claims, an investment contract does not require a contractual obligation between the issuer and buyer, and the SEC adequately pled facts to support a claim that at least one of the crypto assets on Coinbase is an investment contract. Thus, the SEC's claims that Coinbase operated as an unregistered securities exchange, broker, and clearing agency will move to the discovery phase.
But in a boon for self-custody and DeFi, the court sided with Coinbase in dismissing the SEC’s claim that Coinbase Wallet is a broker.
MQD
Judge Failla held the Major Questions Doctrine does not bar the SEC’s suit because crypto is not of sufficient economic and political significance, particularly compared to other cases where the doctrine has been applied. She was also unpersuaded by arguments that Congress is actively considering crypto legislation inconsistent with the SEC's position.
"Until the law changes, the SEC must enforce, and the judiciary must interpret, the law as it is." Opinion at 32-35.
Fair Notice
Judge Failla held that the SEC satisfied its fair notice obligations under the Due Process Clause because Coinbase knew the SEC would apply an investment contract analysis to crypto assets.
"While Coinbase may have come to a different conclusion than the SEC, it can hardly claim to have lacked notice that (i) the legal framework potentially applied and (ii) the SEC could bring an action under it." Id. at 35-38.
APA
Judge Failla held that the APA does not bar the SEC from its suit because "the SEC is not announcing a new regulatory policy, but rather is simply engaging in a fact-intensive application of an existing standard" to determine whether crypto assets are investment contracts. Id. at 39.
Investment Contract Analysis
The Court rejected Coinbase’s argument that an investment contract must carry an enforceable right against the issuer.
"To begin, there need not be a formal contract between transacting parties for an investment contract to exist under Howey." Id. at 45.
"Such a [contractual] requirement, however, is not formal, but formalistic, and cannot be fairly read into the Howey test." Id. at 56.
According to the opinion, courts must look beyond the crypto asset itself and evaluate:
"whether the crypto-assets and the 'full set of contracts, expectations, and understandings' surrounding its sale and distribution — frequently referred to using the shorthand 'ecosystem' — amount to an investment contract." Id. at 46.
Judge Failla also concluded that a buyer's expectation of profit in a common enterprise is not "limited to just shares in income, profits, or assets of a business," but can also include an expectation to profit from "the increased market value of their tokens," as the SEC alleged here. Id at 50.
In finding the SEC adequately pled Howey's third prong, Judge Failla highlighted allegations regarding issuer's public statements promoting: the token as an investment opportunity, the efforts and expertise of the development team, and token burns as a deflationary mechanism. Id. at 51-54.
She also held that purely secondary market transactions can be investment contracts. Id. at 54.
Finally, she rejected Coinbase's argument that without a contractual undertaking element, an investment contract would sweep in virtually all commodities and collectibles:
"Unlike in the transaction of commodities or collectibles (including the Beanie Babies discussed during the oral argument, [ ] which may be independently consumed or used, a crypto-asset is necessarily intermingled with its digital network — a network without which no token can exist." Id. at 59-60.
Staking
The court held the SEC adequately pled facts to show Coinbase offered and sold its staking program as an investment contract given allegations of:
"(i) the risk of loss associated with participation in the Staking Program,
(ii) Coinbase’s significant technical efforts in implementing and maintaining the Program, and
(iii) Coinbase’s promotional efforts to drive customer participation in the Program." Id. at 62-63.
Wallet is Not a Broker
Judge Failla held the SEC failed to allege that Coinbase Wallet functions as a securities broker because the SEC did not allege many factors courts use to identify a broker, and the SEC's allegations did little to suggest that Wallet undertakes routing activities, which are traditionally carried out by brokers. Id. at 81-82.
More specifically, Judge Failla noted:
while Wallet provides access to third party services like DEXs, the SEC did not allege Coinbase performs any key trading functions on behalf of users,
while Coinbase provides pricing comparisons, that activity does not rise to the level of routing or making investment recommendations,
receiving commissions does not turn Coinbase into a broker,
Coinbase has no control over a user's crypto-assets or transactions via Wallet, and the user is the sole decision maker when it comes to transactions. Id. at 78-84.
Thus, "even when considered in the aggregate, the factual allegations concerning Wallet are insufficient to support the plausible inference that Coinbase" acted as a broker. Id. at 83.
What’s Next?
When ruling on a motion for judgment on the pleadings, the court assumes all facts included in the Complaint are true. So for the claims not dismissed, the next phase of litigation is discovery to find out what the facts really are.
See Coinbase's Chief Legal Officer's response here:
Both Chambers are in recess next week.
House returns Tuesday, April 9.
Senate returns Monday, April 8.
Potential April hearings:
House Financial Services hearing on SEC oversight with SEC Chair Gensler.
Senate Banking hearing on illicit finance with Treasury Deputy Secretary Wally Adeyemo.
The Courts
Beba & DEF
Texas-based apparel maker, Beba, and the DeFi Education Fund ("DEF") filed suit against the SEC in federal district court in Texas.
Beba and DEF are seeking:
(1) A declaratory judgement that Beba's airdrops do not constitute investment contract securities.
(2) An order that the SEC's de facto rule of considering virtually all digital assets to be securities violates the APA because the agency failed to provide adequate notice and solicit public input.
KuCoin
CFTC charges KuCoin with operating an illegal digital asset exchange.
Alleges BTC, ETH, LTC, USDC, and USDT are commodities.
DOJ charges KuCoin with Bank Secrecy Act and unlicensed money transmitter violations.
SBF
FTX founder sentenced to 25 years in prison and ordered to pay $11 billion in forfeiture.
CBDC
GOP Majority Whip Tom Emmer makes the case for his anti-CBDC legislation in an op-ed in the Hill.
Sanctions
Treasury sanctioned thirteen Russian entities and two individuals, "including persons developing or offering services in virtual assets that enable the evasion of U.S. sanctions."
Thank you for reading,
GSL
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