Background
On March 22, 2023, the Securities and Exchange Commission (Commission or SEC) issued a Wells Notice to Coinbase, Inc., the largest US-based cryptocurrency exchange and a NASDAQ-listed company.
A Wells Notice is a communication from the SEC enforcement staff (Staff) to a person or entity involved in an investigation informing them that the Staff has made a preliminary determination to recommend that the Commission authorize the filing of an enforcement action against them.
The Wells Notice states that the Staff is prepared to recommend suing Coinbase for alleged violations of Sections 5, 15(a), and 17A of the Securities Exchange Act of 1934 (the Exchange Act) and Sections 5(a) and 5(c) of the Securities Act of 1933 (the Securities Act), which generally prohibit unregistered brokers, dealers, exchanges and others from transacting in unregistered securities absent an exemption. Coinbase has disclosed that the proposed action relates to an unspecified portion of its listed digital assets, Coinbase's staking service and its Coinbase Prime and Coinbase Wallet services. The notice does not specify the nature of the proposed enforcement action but states that it may include a civil injunctive action, a public administrative proceeding and/or a cease-and-desist proceeding. Coinbase is unlikely to be the last crypto exchange to come under SEC scrutiny.
The Staff's close scrutiny of Coinbase is likely to extend to other crypto exchanges. Coinbase had previously disclosed the existence of the investigation in 2022. In addition, there was a prior investigation and Wells Notice in 2021 with respect to Coinbase's intention to launch its Coinbase Lend product, which the company ultimately decided to forego. In addition, multiple securities class actions were filed against Coinbase in the US in 2021, alleging violations of the Exchange Act and the Securities Act as well as certain state-level securities statutes.
The threatened enforcement action hinges on whether at least some of the tokens listed on the Coinbase exchange are securities. The question of whether crypto assets constitute securities has been the subject of significant debate and has been strongly contested by many in the crypto community, including Coinbase. Such resistance is in large part based on the fact the regulatory burden associated with SEC registration can be onerous, and the test the Commission is applying for determining whether crypto assets are securities was developed several decades ago and may not be practical in the crypto asset context.
Notwithstanding such resistance, the SEC's recent actions suggest that it intends to continue exerting jurisdiction in this area. In July 2022, the Commission prosecuted a former Coinbase employee for insider trading based on the argument that the tokens traded by the employee constituted unregistered securities. It has also pursued actions against several other notable crypto exchanges for failing to register crypto asset offerings, most recently against Kraken in February of this year.
Next steps
The issuance of the Wells Notice does not necessarily mean the Commission will sue Coinbase – Coinbase has the opportunity to try to convince the Staff and the Commission to refrain from taking action. However, it is clear that despite the hopes of many in the digital asset world, at present the SEC continues to regulate by enforcement rather than developing crypto-specific regulation. Entities working with digital assets should prepare for increased scrutiny of their products and operations, and they should take proactive steps to determine whether they are compliant with current laws and to otherwise enhance their risk management processes.
Special thanks to law clerk Rebecca Lander for assisting in the preparation of this article.
