In the latest stunning development in crypto policy, one of the industry’s largest exchanges is facing potential charges from the SEC. Coinbase, Inc. said on March 23, 2023, that it had received a “Wells Notice” from the U.S. Securities and Exchange Commission (SEC). A Wells Notice is the SEC’s last communication to a company or individual before an enforcement action. Coinbase gave several details about the notice, providing clues into what the SEC may do next.
In a tweet, Coinbase CEO Brian Armstrong said the SEC is investigating Coinbase’s staking practices, whereby customers can stake or pledge their current crypto holdings and receive passive income in return, usually in the form of additional crypto. Coinbase has several staking programs—on April 22, 2023, it announced it would cease its ALGO crypto service, but reportedly planned at that time to continue its Etherum, Solano and other crypto staking services. The SEC has given staking companies several warnings that their programs may violate U.S. security registration requirements, including the SEC’s February action against Kraken and statements by Chair Gary Gensler.
Armstrong’s tweet also mentioned the SEC was focused on Coinbase’s exchange, whereby customers can trade Coinbase-approved crypto currencies and tokens. The company has a notoriously rigorous review process before listing any crypto assets on its website. Promoters of cryptocurrencies or tokens seeking to have them listed on the exchange must specifically address whether a crypto asset is in compliance with the four-factor securities test—the so-called Howey test—to prove the asset is not an investment contract.
We have some time before we know how this will play out. In terms of next steps, Coinbase has an opportunity to respond to the Wells Notice, known as a “Wells Response.” If Coinbase chooses to submit a response, which is not mandatory, it must be provided to the SEC for review along with other materials. After that, SEC staff will submit their recommendation to the commission to likely vote on approving an enforcement action. This submission will occur in a closed meeting, so unless and until the SEC approves the enforcement action, the public will have little knowledge of its position. Coinbase also may choose to share its Wells Response with the public. Indeed, given that Coinbase has been transparent about its interactions with the SEC and shared its receipt of a Wells Notice with the public voluntarily, it may also decide to share any response it submits. We expect much of its Wells Response will be grounded in the same sort of arguments Coinbase’s chief legal counsel made on its blog in February as to why staking does not violate securities laws.
Assuming the SEC moves forward with an enforcement action, it will be telling to see where it files the complaint, what charges it brings and whether it names the individual officers and directors in addition to the entity. Coinbase is based in San Francisco, but in theory, the SEC could file in other jurisdictions where an investor, (e.g., a Coinbase customer) is present. The agency may seek to use the case to expand the supposed “crypto knowledgeable” jurisdictions in which they can seek relief. So far, the SEC has seen some notable success in the Western District of Washington and the District of New Hampshire, and its latest enforcement action against Kraken was filed in the Northern District of California, which in includes San Francisco. The charges the SEC brings will also be critical. In addition to a Section 5 claim for unregistered tokens, it may also bring a Section 5 case against Coinbase for failing to register as an exchange.
Yet to be seen is whether the SEC will take the groundbreaking step to name individual officers and directors. Failing to register a security is a Section 5 claim under the Securities Act of 1933. This claim is strict liability, meaning the SEC does not need to prove the officers and directors knowingly violated the securities laws. To date, the SEC has been resistant to naming individual officers and directors in stand-alone Section 5 claims. For example, the SEC named the officers in its enforcement action against Ripple Labs for its unregistered crypto token, XRP, but that was also based on an allegation that the executive officers personally engaged and touted unregistered sales and made $600 million in proceeds. If the SEC names the officers and directors, it will show a significant ramp up in its efforts to police the industry. Being named and found guilty of a securities crime usually comes with a bar against serving as a director and officer in another public company, steep penalties and prejudgment interest.
Also, regarding the Ripple Labs case, a central question is whether the company lacked notice that the XRP token was an unregistered security. This defense is known as the “fair notice defense,” which any enforcement action by the SEC against Coinbase would likely be implicate. A ruling could be issued this year in Ripple Labs, which could impact the viability of Coinbase successfully asserting the fair notice defense.
Under Rule 5(c), Coinbase has certain limitations for what it may include in its Wells submission, including a 40-page limit, or a 10-minute verbal presentation. The SEC can then choose to reject or accept the submission, which does not mean the SEC will decline to seek an enforcement action. By law, the SEC has to file an enforcement action within 180 days of its Wells Notice, if it so choses to move forward. We suspect we will know how this plays out long before the SEC’s September deadline.
This document is intended to provide you with general information regarding the SEC's efforts to regulate cryptocurrency. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions. The information in this article is accurate as of the publication date. Because the law in this area is changing rapidly, and insights are not automatically updated, continued accuracy cannot be guaranteed.