The U.S. crypto exchange Coinbase defended its business model in a New York courtroom on Wednesday as it faces an existential lawsuit from the Securities and Exchange Commission.
Arguing in front of Judge Katherine Polk Failla of the Southern District of New York, Coinbase’s lawyers sought to dismiss the SEC’s lawsuit from June 2023 that alleges the firm operates illegally by offering crypto trading and staking services without first registering with the agency.
Failla spent five hours grilling each team of lawyers. Central to the lawsuit is the debate over whether crypto assets are securities, and therefore overseen by the SEC. The agency has long argued that the Howey test, a Supreme Court framework established in 1946, ensures that most crypto assets fall under existing securities law. Crypto advocates, including Coinbase’s lawyers, argue that Howey does not apply to the novel structure of crypto assets and that the SEC is overreaching.
As the crypto industry clamors for regulatory clarity amid a bevy of lawsuits from the SEC, Coinbase’s court case represents a key pivot point for the embattled sector, with a loss potentially crippling the ability of many digital asset firms to operate in the U.S.
‘Contractual undertaking’
Although cryptocurrencies have existed for 15 years, with Bitcoin created in 2009, the SEC has dragged its feet on clarifying whether major crypto assets like Ether and Solana fall under its regulatory remit. (The agency has conceded that Bitcoin is a commodity.)
That changed in a series of lawsuits brought by the SEC against different token issuers and intermediaries, starting with a 2020 case against Ripple, the creator of XRP. After the broader collapse of the crypto industry in 2022, the SEC ramped up its efforts, suing Terraform Labs as well as exchanges including Coinbase, Binance, and Kraken.
In each of the lawsuits, the SEC made a similar argument: Howey establishes that a security is an investment in a common enterprise with the expectation of profit derived from the profit of others. The agency argued that different cryptocurrencies satisfied the criteria, meaning that many platforms selling the assets weren’t operating in compliance.
At Wednesday’s hearing, Patrick Costello, the SEC’s assistant chief litigation counsel, expanded on the agency’s view that the tokens themselves are not a security—but that when customers buy them on a platform like Coinbase, they’re investing in the network behind the tokens, whose issuers often make promotional statements to boost their value. “One cannot be separated from the other one,” he said.
The question has already been contested in two other cases decided at SDNY. In the Ripple lawsuit, Judge Analisa Torres found that XRP was an investment contract only when sold to institutional investors but not in the open market—secondary sales, like on Coinbase. Just a few weeks ago, Judge Jed Rakoff disagreed, establishing a broader definition of crypto asset securities in the SEC’s lawsuit against Terraform Labs.
Led by William Savitt, the co-chair of litigation for Wachtell, Lipton, Rosen & Katz, Coinbase’s legal team seemed to take an even looser view than Torres’s ruling. He argued that the Howey test did not apply to cryptocurrencies sold on Coinbase at all because there’s no explicit investment contract present—sales on secondary markets like Coinbase are just trades between strangers.
Failla noted how the SEC’s stance could push the boundaries of securities into realms it doesn’t intend to venture into, including collectibles. The SEC sought to establish a “limiting principle,” arguing that investors buying tokens with the understanding that they were buying into the ecosystem—driven by promotional materials—would create an investment contract. Savitt argued that many commodities, such as gold, have promotional statements, and what sets securities apart is the “contractual undertaking that gives an interest in the business.”
‘Just out of luck’
While discussions around Howey ate up most of the hearing, the judge also weighed two other debates. The first surrounded staking, a product offered by Coinbase that allows users to deposit certain cryptocurrencies to earn a yield.
As an SEC attorney explained, Coinbase is taking an established technology—in this case, the staking rewards program endemic to certain blockchains like Ethereum—and building an enterprise on top of it, which they say constitutes an investment contract.
Coinbase’s counsel disagreed, arguing that the tokens always belong to the users, not Coinbase, and that the users are merely hiring Coinbase to stake the tokens on their behalf.
A more contentious—and potentially consequential—debate hinged on the Major Questions Doctrine, another Supreme Court precedent that states Congress should not delegate issues of major political or economic significance to agencies like the SEC. In other words, the SEC should not create its own de facto legislation for consequential issues without explicit instructions from Congress.
Failla referenced how Congress is actively weighing crypto legislation and how Sen. Cynthia Lummis (R-Wyo.) even filed a brief arguing in favor of Coinbase that questioned whether the judge would be stepping outside her lane by creating precedence in the absence of congressional action. The agency argued that crypto’s relatively small imprint on financial markets meant that the Major Questions Doctrine did not apply, and that the SEC’s duty is to apply existing securities laws to new financial sectors.
In her questioning of Coinbase’s lawyers, Fallia seemed hesitant to apply the Major Questions Doctrine, alluding to the fact that it is rarely invoked in decisions. “I worry that I am, in my own lane, doing exactly the thing that you’re arguing the Commission is doing here, which is to take power I don’t have to stop activity I shouldn’t be stopping,” she said. “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.”
Acknowledging her reticence, Coinbase’s counsel argued that the SEC was effectively creating rules through enforcement actions against a nascent industry. “The SEC should follow enforcement and rulemaking actions that make sense of the statutory language and that does not twist it upside down,” Savitt said in his closing summation.
After five hours, Failla didn’t issue a ruling from the bench. She asked for more time to weigh the arguments.