Last week, Coinbase Global Inc. (“Coinbase”) headed off confrontation with the Securities and Exchange Commission (“SEC”) by announcing it was shelving a much ballyhooed digital asset lending product, Lend. The announcement came two weeks after Coinbase revealed that it had received a Wells notice from the SEC warning the company of its plans to sue over Coinbase’s planned October Lend launch.
The product was said to offer users a high-yield alternative to traditional savings accounts, allowing them to loan their USDC stablecoin to Coinbase at 4% interest. After its receipt of the Wells notice, the crypto company took to the Internet to criticize the SEC, who apparently issued the warning after a months-long effort by Coinbase to engage productively with the Commission, according to the company. This episode demonstrates that while digital asset innovation marches on, regulators now seem poised to go to market with enforcement actions targeting these novel instruments.
The issuance of a Wells notice following discussions between the SEC and its investigative quarries is common. What is not so common is a Wells notice that threatens enforcement action for conduct that has yet to occur. This is because, traditionally, the Wells notice serves the purpose of informing the subject of a preliminary determination to recommend that the SEC initiate proceedings for past misconduct. Here, the SEC’s decision to move forward with enforcement appeared to be contingent on Coinbase’s future launch of Lend.
Coinbase has claimed that the SEC refused to provide the legal rationale for issuing the Wells notice, except that the regulator had apparently determined that Lend “involve[s] a security,” requiring registration in light of two landmark Supreme Court cases: Securities & Exchange Commission v. W.J. Howey, 328 U.S. 293 (1946) and Reves v. Ernst & Young, 494 U.S. 56 (1990).
In Securities & Exchange Commission v. W.J. Howey, the Supreme Court established the famed Howey Test that frequently is employed in the digital asset space to determine whether these novel products are securities subject to SEC registration and oversight. Under the Howey Test, an investment instrument is a security where there is: (1) the investment of money, (2) in a common enterprise, (3) with the expectation of profit, (4) derived from the efforts of others.
Interestingly, according to Coinbase, the SEC also cited Reves v. Ernst & Young, a Supreme Court case establishing when a lending instrument constitutes a security. While the term “note” is included in the statutory definition of a security, under the federal securities law, notes with a maturity of nine months or less are not securities. See Securities Act of 1933 § 3(a)(3); Securities Exchange Act of 1934 § 3(a)(10). Moreover, courts have carved out additional exceptions through case law, and Reves established that notes are not securities if they bear a “family resemblance” to excepted categories, including: (1) notes delivered in consumer financing; (2) notes secured by a home mortgage; (3) short-term notes secured by a lien on a small business or some of its assets; (4) notes evidencing a character loan to a bank customer; (5) short-term notes secured by an assignment of accounts receivable; (6) notes that formalize an open-account debt incurred in the ordinary course of business; and (7) notes evidencing loans by commercial banks for current operations. That the SEC apparently cited both Howey and Reves in support of its position may indicate the regulator determined that some aspect of Lend constituted a security as both an investment contract and a note.
While Coinbase’s decision to forgo its planned launch of Lend apparently avoids a head-on collision with the SEC, the events of the past month demonstrate both the SEC’s readiness to pursue enforcement action in the digital asset space as well as the crypto industry’s dissatisfaction with the guidance provided by the SEC regarding the ground rules for conducting digital business. Without such guidance, episodes like this one may become commonplace.
Copyright © 2021, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume XI, Number 272