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Coinbase’s Dismissal Request Challenged by SEC: Agency Highlights Staking & Wallet Concerns

Published October 4, 2023 12:11 PM
James Morales
Published October 4, 2023 12:11 PM
Key Takeaways
  • The SEC wants Judge Katherine Polk Failla to throw out Coinbase’s motion to dismiss a lawsuit brought by the regulator.
  • Offering rebuttals to Coinbase’s arguments, the SEC maintains that the initial grounds for its lawsuit stand up to legal scrutiny.
  • Coinbase and the SEC disagree over the interpretation of key terms derived from the Howie Test.

The US Securities and Exchange Commission’s (SEC) various legal bids to establish its authority over the American crypto sector by classifying most major tokens as securities haven’t quite gone according to plan.

Despite recent setbacks, the SEC remains determined to pursue its lawsuit against Coinbase, refusing to drop the case and urging the court to dismiss Coinbase’s motion.

SEC Has No Intention of Giving up Coinbase Fight

Of all the SEC’s ongoing lawsuits against crypto firms, its legal battle with Coinbase holds totemic significance for the entire US crypto sector.

Of all the crypto exchanges that operate in the US, Coinbase has arguably done the most to establish a dialogue with the regulator, attempting time and time again to create a way forward that both sides can agree on.

Yet despite its efforts, ultimately, Coinbase was unable to prevent the SEC from suing it for selling unregistered securities. And if one of the world’s largest and richest exchanges can’t get the SEC on board, what chance to the rest of them have?

After the SEC filed its initial complaint against Coinbase, the American company asked  the judge to throw the case out on the grounds that there was no legal basis for considering cryptocurrencies as securities.

Now, nearly 4 months later, the SEC has responded  by urging Judge Katherine Polk Failla to dismiss Coinbase’s petition.

How Courts’ Interpretation of the Howey Test is Evolving

The SEC derives its regulatory authority from the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws grant the SEC control over sales of securities, defining an asset’s securities status based on the presence of an ‘investment contract.’

However, the original legislation didn’t strictly define what counts as an investment contract. To do that, the Supreme Court had to weigh in, which it did in the 1946 case of SEC vs W.J. Howey Co.

In the nearly 80 years since the Howey case was heard, the Supreme Court’s ruling against the SEC has come to define whether or not specific asset classes should be considered securities.

According to the SEC, the vast majority of cryptocurrencies pass the four pillars of the Howey Test.

In other words, the SEC claims that crypto sales constitute investment contracts because they 1) entail an investment of money, 2) establish a common enterprise among investors, 3) rest upon an expectation of profits by investors and 4) require the efforts of others to create that profit.

What Does the Court Challenge?

While courts typically haven’t questioned the SEC’s application of the first three principles to crypto tokens, it challenged its insistence that the expectation of profits requires the efforts of others.

For example, in the ongoing case of Ripple vs the SEC Judge Analisa Torres ruled that XRP sales directly to institutional investors constituted an investment contract. However, she dismissed the SEC’s claim that XRP sales on crypto exchanges pass the 4 requirements of the Howey Test.

Significantly, on Tuesday, Judge Torres dismissed the SEC’s appeal against her original judgment.

Referring to the language of the 1946 Howey ruling, she said that the SEC had failed to provide evidence that XRP’s exchange buyers’ “speculative motive derived from the entrepreneurial or managerial efforts of others.”

Staking and Wallets Central to SEC’s Legal Argument

In its motion to dismiss the SEC’s lawsuit, Coinbase referred to the first and the fourth pillars of the Howie Test.

Specifically, it asserted that its crypto staking program does not constitute “an investment of money” because Coinbase customers don’t forfeit their crypto, which Coinbase argues it simply stakes on their behalf.

In its rebuttal to that claim, the SEC wrote that “courts have never imposed any requirement that investors give up permanent control over the capital deployed into the enterprise.”

It added that “Coinbase ignores that it requires staking investors to transfer the staking-eligible assets to Coinbase’s omnibus wallets, where they are commingled and treated as fungible.”

As well as the “investment of money” aspect of the Howy Test, Coinbase has also objected to the SEC’s interpretation that its staking program requires the “managerial” efforts of others to generate a profit for users.

For its part, Coinbase argues that it simply acts as a mediator, facilitating staking, but not actively managing the process.

Meanwhile, the SEC contends that the way the exchange operates its staking pools constitutes exactly the kind of “management” the Howey Test deems central to the definition of an investment contract.

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