A September To Remember: Coinbase Avoids SEC Clash By Dropping Crypto Lend Product – Technology

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.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.