The Breakdown - The Huge Significance of the Coinbase vs. SEC Hearing

Episode Date: January 19, 2024

Coinbase is seeking for the judge to throw out the SEC's lawsuit against them. NLW covers why the extensive hearing this week was such a big deal when it comes to legal interpretations surrounding crypto issues. Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Thursday, January 18th, and today we are talking about Coinbase versus the SEC. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown. pod. Well, friends, we have an interesting one today, a big legal battle with some serious significance, and one more indicator of how important the legal system is when it comes to the crypto industry in America right now. So, here's what was going on. Yesterday, Coinbase and

the SEC appeared in New York Federal District Court for the first substantial hearing in their case. Across a five-hour hearing, Coinbase justified their position that the court should be thrown out before it even gets started. Now, the SEC for their part argued that the lawsuit has merit and should be allowed to continue to trial. The SEC are putting forward two major claims against Coinbase, that their staking as a service product is sold as an unregistered security, and more critically, that the tokens offered on their trading platform are sold as unregistered securities. This would mean that Coinbase has failed to register with the SEC regarding their retail exchange, their prime brokerage,

and their wallet services. The SEC presented a dozen examples of non-compliant tokens, with the most prominent ones being Solana, Cardano, and Maddoch. In many ways, this case along with the Binance case, is positioned to decide whether crypto tokens in general fall under the SEC's jurisdiction as unregistered securities. Now, this was a preliminary hearing, confined solely to deciding whether Coinbase should succeed in their motion for judgment on the pleadings,

which is basically a fancy way to say a motion to dismiss, or at least is similar. Legal bros don't come at me. If Coinbase succeeds across all of their arguments, the case could be terminated at this stage. If they fail, the case would continue through the legal process. Discovery of evidence would come next and eventually a full trial, a process that could likely take years to fully play out. Now, of course, the stakes are high for Coinbase, as this is an opportunity to rid themselves of the lawsuit early, but it should be noted that it is not a must-win

hearing. Experts noted that it's highly unusual to hold an extensive hearing at this stage, which points to the complexity and importance of the arguments being made. Coinbase also has a high legal standard they need to reach to have the case decided at this stage. A complete decision at this point can only deal with differences in the interpretation of the law rather than factual disputes. The presumption is that the legal process should be allowed to play out in full, so cutting the lawsuit short before discovery requires an overwhelming argument as well as clear facts. The case is being heard by Judge Fahlia, who has a lot of experience in dealing with crypto cases. She presided over the fraud and market manipulation case brought against Bitfinex and Tether in 2019.

She was also the judge who dismissed the class action against Uniswap last year. Fahlia has demonstrated a deep interest in getting the technical facts correct in crypto cases to ensure she can come to an accurate interpretation of the law. This case has been assisted by numerous amicus or friend of the court briefs provided by legal scholars and members of the crypto industry. These briefs presented by third parties to the lawsuit are usually intended to inform the court on interpretations of the law. In this case, there were also several briefs which provided detailed technical descriptions

of the crypto services in question. Now, let's talk about staking and technical descriptions. Judge Fahlia has already been highly skeptical of the SEC's arguments during early proceedings. This skepticism was evident from the very beginning of yesterday's hearing. Fahlia said that she had a lot of questions for both parties, but launched straight into querying the way the SEC had described Coinbase's staking service. She asked the SEC whether they objected to her relying on the technical description of crypto staking

from Coinbase's filings. Fahlia explained further. Let's imagine that the SEC has described staking in a manner that runs contrary to everyone else's description of it. She added, The Defi People have what I think is a really fine amicus brief, explaining to me what staking really is, and that in some respects makes more sense to me

than the SEC's description from the complaint. Now, the Defi People refers to the Defi Education Fund, who placed a technical brief on the record with Fahlia referred to as DFI for dummies. Fahlia put to the SEC, you're suggesting to me that it's a factual dispute I simply can't resolve, even if, for example, the SEC's description of staking is demonstrably wrong?

Now, Coinbase's argument about staking hinges on the idea that the company is merely allowing users to access a native property of some blockchains. During the hearing, they described customers as hiring Coinbase or subcontracting their staking. They noted that customers retain ownership of their tokens while using the staking service. The argument here is that users aren't expecting a profit to come from Coinbase itself, but rather from the underlying staking yield. As an early positive sign, Thalia said that she found staking to be the, quote, least traditional investment-like of the functions that you were complaining about here. Still, the bulk of the hearing related to whether crypto tokens are sold as unregistered securities on Coinbase's exchange. This legal

question is determined by the Howie Test, which identifies situations where an investment scheme is deemed to be a securities offering. Under the Howie Test, an investment contract is deemed to exist if four elements are satisfied, that there is an investment of money, in a common enterprise with the expectation of profit, to be derived from the effort of others. The last two elements are typically read together, meaning that the expectation of profit has to be directly connected to the efforts of others. For example, that was one of the places where the SEC fell short in the Ripple case. The court determined that most retail investors were expecting their profits to come from speculative mania in crypto markets rather than from the efforts of the Ripple

Corporation. Moving to the tokens, Judge Valia made sure to get one thing very clear from the start. She extracted an acknowledgement from the SEC that, quote, the tokens themselves are not a security. In response, Falii equipped, that's what the folks in the back table, Coinbase think, and they are wondering why we are here. This legal point came to a head in the Ripple case and has severely hampered the SEC's attempt to paint the crypto industry with a broad brush. In Ripple, the judge determined that the tokens do not carry any contractual rights, so are not deemed to be securities or investment contracts. Instead, the manner in which the tokens are sold can involve an investment contract based on the representations made alongside that sale.

This is why sales to institutional investors, which included marketing material, were deemed to be securities transactions, while secondary sales through a crypto exchange were not deemed to be securities transactions. The SEC presented a novel legal argument to get around the Ripple decision when it comes to secondary sales on Coinbase. They argued that when customers buy tokens, they are investing in the network behind the token stating, one cannot be separated from the other one. They noted that crypto networks often put out promotional material designed to boost the price

of the token. Their claim was that an investment in a protocol with a community and an ecosystem was enough to satisfy the Howie test. When asked why that argument wouldn't apply to Bitcoin, the SEC said, there is no ecosystem behind it. Coinbase noted that Bitcoin absolutely has an ecosystem, recognizing the work of thousands of developers who maintain and improve Bitcoin. Coinbase presented their view that the Howie test does not apply to tokens on the exchange

because there is no investment contract present. They noted that token holders have no contractual rights with the underlying protocol, unlike investments in stocks and bonds. Coinbase stated, Everybody has always known that investment contracts have to have contracts. They pointed out that the SEC has never stepped away from that premise before the crypto enforcement cases began. Addressing marketing material from crypto projects,

Coinbase said, Every commodity has promotional statements around it, and they aren't all securities. What makes it different is the contractual undertaking that gives an interest in the business. Their point was that buying into a protocol ecosystem is not enough for the Howie Test, there needs to be a legally enforceable promise made to investors.

Coinbase did not argue that this needs to be a signed contract, but said that there needs to be something more than reading promotional material. Today's episode is brought to you by Cracken. For far too long, the whole financial system has been standing still, too slow, only on for certain hours, overly designed for some types of people, but not for others. Crypto, at its best, represents progress. It asks the question, what if? It invites people in instead of leaving them out. It's on 24-7, 365,

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of collectibles and the limits to SEC jurisdiction. Falia said, I'm presented with the specter of collectibles being regulated by the SEC. I've not thought about Beanie Babies in decades, and yet it's being presented to me in multiple briefs. The SEC quickly chimed in that they are not contending that Beanie Babies are securities. Volia responded, we're all just afraid that you have so little limitation on your standard that some really thoughtful attorneys are going to bring the Beanie Baby class action. She said she was concerned the SEC's argument was sweeping too broad

and could capture all manner of collectibles and even commodities. Now, this argument was raised extensively in the Coinbase filings in Amicus briefs. The point wasn't that crypto investment is based on speculation like Beanie Babies. Rather, the argument that Coinbase made is that without a meaning of the money meaningful limiting principle, SEC jurisdiction could expand to cover all investments. Coinbase said, the SEC's position of give us this mandate and trust us with it simply doesn't work. Now, towards the end of the hearing, arguments turn toward the major questions doctrine. This is a recently developed legal principle, which is being argued in active Supreme Court

litigation currently. It holds that Congress must explicitly give government agencies rulemaking authority over major segments of the U.S. economy. This authority can't be implied from existing legislation, it must be considered specifically. Recent cases have dealt with student debt relief and greenhouse gas emissions. In both cases, the Supreme Court ruled that Congress must pass new legislation to assign authority to government agencies. The topic is so current that there was a case argued in the Supreme Court yesterday based on the major questions doctrine. The case is about commercial fishing regulation, but seeks to remove some of the deference granted to government agencies more broadly. Crypto was mentioned as one of the prime examples,

with one lawyer stating, I would think the uniquely 21st century phenomenon of cryptocurrency would have been addressed by Congress. It hasn't. Why? Because there is an agency head out there who thinks he already has the authority to address this uniquely 21st century problem with a couple of statutes passed in the 1930s. He's going to wave his wand and say the words investment contracts are ambiguous, and that's going to suck all of this into my regulatory orbit, even though that same person when he was a professor said this is probably a job for the CFTC. Now, Coinbase are arguing that the crypto industry is important enough to the U.S. economy to be subject to the major questions doctrine. For this argument to be successful,

the legal standard is a question of, quote, vast economic and political significance. The SEC said the crypto industry doesn't reach this level, stating, with all due respect to the crypto industry, it does not meet the economic significance test. They say crypto has a trillion dollar market cap, but that's global and includes Bitcoin. The U.S. equity market is 100 trillion in global market, 400 trillion. Crypto is a rounding error. Coinbase retorted that their argument should be considered not because of the novel nature of crypto, but rather because the SEC is attempting to expand its jurisdiction well beyond what Congress intended. Judge Fahlia noted that in her 10 years on the bench, she has never been presented with an MQD argument. She appeared uncomfortable with making a decision

more suited for the Supreme Court, stating, I have a natural hesitation to make a finding that something implicates the major questions doctrine because I'm not sure it's on par with student loan forgiveness in the energy industry. I worry that I would be doing exactly the thing you're alleging the SEC is doing here, which is to take the power that I don't have to stop activity I shouldn't be stopping. I do have a concern about not recognizing someone's authority to do something in this space. The answer may be that I'm just out of luck until Congress acts. Fahlia referred to the major questions doctrine then as the nuclear option in this case. Now, this was one of the few places where Coinbase failed to put forward a convincing argument. It's still important that the

point was raised, but it seems that the major questions doctrine argument might be more appropriate for an appeal. Still, perhaps the biggest takeaway from the hearing was that Judge Fahlia is deeply engaged in the case and has done the work to understand crypto. She leaned heavily on technical briefings from the industry and understood the impact of this case. At one point, she told the SEC, I actually care about how you're defining security because I want to understand not only how it applies to this case, but what it's going to mean to individual purchasers of these crypto assets going forward. Halfway through the hearing, there was a lengthy discussion of the amicus brief filed by Cynthia Lummis. The SEC said Senator Lummis respectfully is wrong.

They suggested that a senator should not be able to override 90 years of securities law. Fahlia did not take kindly to this comment, pointing out, Llamas is not a random senator. She's someone deeply involved in the space. Also, don't keep saying respectfully when you really mean to malign someone. I have a lane. The SEC has a lane. Congress has a lane.

I received an amicist brief from a sitting congresswoman saying, don't do this, Fahlia. I need to take that seriously. Drawing language from the Lumbus brief, Fahlia added. Lumbus isn't saying she wants to overturn securities laws, but that they had a good 90-year run and now we have insurance. that do not fit. Should the SEC fill the void with assets that may not be securities or commodities? In closing, Coinbase summarized their argument by stating,

the SEC should follow enforcement and rulemaking actions that make sense of the statutory language and that does not wish to twist it upside down, that does not leave the word contract out of the word contract, that harmonizes rather than does violence to all of the cases that have come before it. And this is several bridges too far. Fahlia ended the hearing, however, without delivering a decision. She said, there's not an argument you haven't made to me. I just have to decide. which one makes more sense. A ruling on this motion is not expected for weeks, if not months. Now, when it comes to the community's reaction, overall it was positive. Jake Trevinsky, the chief legal officer at Variant Fund, wrote, today's Coinbase hearing revealed a key flaw of the

SEC's legal theory. It turns nearly every asset on the planet into a security. This can't be true. The SEC was created to regulate market for financial instruments, not digital goods or the technologies empowering them. Judge Valia seemed to get this flaw quite well. The SEC has clearly gone way off mission in its attempt to regulate crypto. It's a policy failure as much as a legal one made worse by the SEC calling crypto a rounding error today. This doesn't mean Coinbase will necessarily win its motion for judgment on the pleadings, but it does display the true emptiness of policymakers' claims that the law is clear and the industry just doesn't want to comply. It's a fight, but we have the high ground. Bill Hughes from Consensus honed in on the same problem. The bigger problem for the

SEC is that they have not and cannot come up with a coherent answer for how does your position not create a situation where any investment can be deemed a security. The trial team is not authorized to draw lines here. The SEC attorneys would prefer to sound nonsensical than to say something which admits a limitation on the SEC's authority. Marissa Tashman-Coppel, the head of legal at the blockchain association, pointed out what many felt after seeing the seriousness with which the judge was taking the situation. She wrote, Judge Fahlia came prepared with thoughtful questions, had digested the amicus briefs, understands the tech, and gets the dynamics at play between the SEC in Congress. She has tuned into the SEC's overreaching and demonstrated her awareness of recent

congressional acts indicating legislation is necessary. She pushed back on the SEC's framing of both the technology and the law, particularly on Coinbase's staking program and the absurdity of regulating collectibles as securities, although it is impossible to predict with her opinion will say, if you'll optimistic, it will contain at least some positive language. Listen, friends, I think this is a big one. I think it's not done yet. Not a lawyer, but I would be surprised if this isn't allowed to proceed. Just based on how many questions remain, I think the victory was, as exactly some people have pointed out, that it just obliterates the idea that everything is clear and that we're just a bunch of malcontents who don't want

to follow the law. In that alone, this was major progress. And if we have every judge who spends as much time and attention and care as this judge does, even when those decisions go against us sometimes in the future, overall, I think will be in good shape. That's going to do it, however, for today's breakdown. One more big thank you to my sponsor for today's show, Cracken. Go to crackin.com and see what crypto can be. Until next time, be safe and take care of each other. Peace.