Five Key Facts Supporting the SEC's Lawsuit Against Coinbase for Violating Securities Laws

Compiled by: angelilu, Foresight News

Following the U.S. Securities and Exchange Commission (SEC) suing Binance, the SEC has struck again in less than a day, filing a lawsuit against the cryptocurrency exchange Coinbase in a federal court in New York today. This lawsuit reflects the regulatory challenges and legal disputes faced by cryptocurrency exchanges. Foresight News has organized the 101-page complaint released by the SEC, extracting five major factual bases on which the SEC accuses Coinbase of violating securities laws.

I. Coinbase's Operations and Its Relationship with CGI

Coinbase launched the initial version of its trading platform in 2012, initially supporting "anyone, anywhere, to easily and securely send and receive Bitcoin." Today, the Coinbase platform has evolved into a scalable online trading platform for customers to buy, sell, and trade hundreds of crypto assets.

In addition to the Coinbase platform, Coinbase also offers a range of other services for customers in the U.S. and abroad, including the Prime and "self-custody" wallet Wallet launched for its institutional clients in May 2021. Besides facilitating secondary market trading through cryptocurrency asset transactions, Coinbase also allows issuers to sell cryptocurrency assets for the first time through Coinbase's "Asset Hub."

Coinbase claims to serve over 108 million customers, including U.S. customers, with daily trading volumes in the billions of dollars. Today, the Coinbase platform is one of the largest cryptocurrency trading platforms globally and one of the largest in the U.S., having experienced exponential growth in recent years: in April 2021, Coinbase offered about 55 crypto assets for trading on its platform; as of March 2023, this number had increased to approximately 254 assets. Additionally, as of December 2022, Coinbase allowed users to trade over 16,000 crypto assets through its wallet.

Most of Coinbase's revenue comes from transaction fees charged on cryptocurrency asset transactions conducted through the Coinbase platform, Prime, and Wallet. For example, in 2021, Coinbase generated $6.8 billion in "transaction revenue" out of a total net revenue of $7.4 billion. Similarly, in 2022, Coinbase generated over $2.2 billion in transaction revenue out of a total net revenue of $3.1 billion.

The revenue and fee flows generated by Coinbase go to Coinbase's parent company, CGI. For instance, CGI's consolidated balance sheet and operating statement for 2022 include: funds and crypto assets and liabilities related to Coinbase services; total revenue generated from Coinbase services; technology and development expenses of Coinbase; and sales and marketing expenses of Coinbase.

Coinbase and CGI share the same board of directors, and most of CGI's executives hold the same executive positions at Coinbase, including Brian Armstrong, who serves as CEO of both Coinbase and CGI. The two entities operate through the same website (Coinbase.com) and disseminate public information through the same blog, Twitter feed, Facebook page, LinkedIn page, and YouTube channel.

In fact, in public statements, Coinbase and CGI do not distinguish between each other. For example, for 2022, the publicly traded company defines its "company" in the comprehensive report 10-K submitted to the SEC as including Coinbase and its other consolidated subsidiaries, while its "business" is described as providing "a secure, trustworthy, and easy-to-use platform that offers access to the crypto economy through custodial and self-custodial solutions for three customer groups (consumers, institutions, and developers)."

II. Coinbase Provides Exchange, Brokerage, and Clearing Agent Services to U.S. Customers Through the Coinbase Platform, as Well as Brokerage Services Through Prime and Wallet

Coinbase has never registered with the SEC as a national securities exchange, broker, or clearing agency, and is not eligible for registration exemptions. However, Coinbase has acted as an exchange, broker, and clearing agency in its services since 2019, including through the following actions:

A. Coinbase Solicits Customers and Facilitates Trades

This includes using the Coinbase blog and its Twitter account with over 5 million followers, as well as spending hundreds of millions of dollars annually on marketing and sales to maintain and recruit new investors.

B. Coinbase Holds and Controls Customer Funds and Crypto Assets

Coinbase requires customers seeking to buy or trade through the Coinbase platform and Prime to create an account on Coinbase.com and transfer their crypto assets or fiat currency to Coinbase. Once assets are transferred to Coinbase, Coinbase credits the corresponding amount to the customer's account in its internal ledger. Coinbase's internal ledger separately tracks each customer's crypto assets and fiat currency for each deposit and withdrawal, but Coinbase otherwise commingles customer funds and crypto assets of similar nature.

The Coinbase user agreement applies to certain services of Coinbase (including the Coinbase platform and staking program), which stipulates that the crypto assets and fiat currency transferred to Coinbase by customers are "custodial assets held by Coinbase for (the customer's) benefit."

Specifically, the user agreement states that customers' crypto assets are held by Coinbase in digital wallets, which, according to Coinbase, allow customers to "store, track, transfer, and manage" their crypto asset balances. However, Coinbase "stores the private keys for digital assets used to process transactions in a combination of online and offline storage." Coinbase uses "shared blockchain addresses" (i.e., comprehensive wallets on the relevant blockchain) controlled by Coinbase to hold customers' crypto assets in Coinbase's digital wallets. Coinbase does not create "isolated blockchain addresses" for each customer's crypto assets and treats similar types of crypto assets held in its wallet as "fungible and equivalent to each other across multiple blockchain protocols."

C. Coinbase Maintains and Provides a Market and Facilities for Trading Crypto Assets Through the Coinbase Platform

Coinbase explicitly states that when customers buy or sell crypto assets through Coinbase, they are not buying from or selling to Coinbase. Instead, the Coinbase user agreement states that Coinbase acts as an "agent" to facilitate trades on behalf of customers, allowing them to buy and sell crypto assets among themselves.

As shown in the diagram below, the design and functionality of the unregistered Coinbase platform are similar to those of a formally registered national securities exchange, including: (1) order display, (2) order book and order types, (3) order matching and trading rules.

D. Coinbase Settles Customer Transactions

After the matching engine matches orders between customers on the Coinbase platform, Coinbase's trading rules state that Coinbase immediately settles the transactions. This is done by debiting and crediting each customer's account on its maintained internal ledger to track customer balances in crypto assets and fiat currency. Coinbase claims that these debits and credits occur "off-chain," meaning that the transaction records are kept on Coinbase's internal ledger rather than on any blockchain. Subject to daily withdrawal limits, customers can immediately arrange to withdraw their assets from their accounts by instructing Coinbase to transfer their assets to another blockchain wallet (or to transfer fiat currency to the customer's bank account) after the transaction settles.

E. Coinbase Charges Fees for Executed Transactions

Coinbase charges fees for transactions executed through the Coinbase platform and Prime. For transactions on the Coinbase platform, the fees are either a percentage of the order amount, up to 0.60%, or a flat fee based on the transaction value. Coinbase charges transaction-based fees for its Prime order routing and execution services, and customers can choose between a single comprehensive fee or a transparent, uniform commission in addition to the transaction fees. During the relevant period, at least until March 2023, Coinbase charged a fixed fee of 1% for each transaction executed through the swap/trade feature in Wallet.

III. The Crypto Assets Traded on the Coinbase Platform and Through Prime and Wallet Include Assets Offered and Sold as Securities

A. Before Offering Crypto Assets, Coinbase Conducted Risk Assessments to Confirm the Potential Application of Federal Securities Laws to Its Products and Services

B. CGI Has Publicly Disclosed the Risks of Coinbase's Unregistered Operations

C. Coinbase Has Made Available Assets Offered and Sold as Securities

Among them, the SEC has classified SOL, ADA, MATIC, FIL, SAND, AXS, CHZ, ICP, NEAR, VGX, DASH, and NEXO as securities.

Related content recommended for reading: 《Seeking Compliance but Giving Others a Handle, Is Coinbase Digging Its Own Grave?》

IV. Coinbase Has Been Required but Has Not Registered as a U.S. Securities Exchange, Broker, and Clearing Agency

Coinbase aggregates orders from multiple buyers and sellers of crypto assets, offering and selling these crypto assets as securities using a trading facility that employs non-discretionary rule programming for order interaction, allowing buyers and sellers to agree on the terms of trading these securities. Therefore, Coinbase has been required to register with the SEC as a national securities exchange or operate under an exemption from such registration, but it has not done so.

Through the Coinbase platform, Prime, and Wallet, Coinbase engages in the business of trading securities for others, facilitating the trading of crypto asset securities through accounts and digital wallets controlled by Coinbase, opening customer accounts, processing customer funds and crypto assets (which it commingles and treats as fungible), and thus receiving compensation. Therefore, Coinbase has been required to register with the SEC as a broker or operate under an exemption, but has not done so.

In the settlement of crypto asset securities transactions occurring on the Coinbase platform, Coinbase acts as an intermediary and also serves as a securities custodian, requiring customers to store crypto asset securities in wallets controlled by Coinbase, creating a centralized processing system for securities, whereby the securities stored and traded on the Coinbase platform are treated as fungible securities, and customer accounts are debited and credited by Coinbase to settle customer transactions. Therefore, Coinbase has been required to register with the SEC as a clearing agency or operate under an exemption, but has not done so.

V. Coinbase's Staking Program Violates Section 5 of the Securities Act by Engaging in Unregistered Securities Offers and Sales

Coinbase has deprived investors of important information regarding Coinbase and its staking program offerings, including how Coinbase uses the proceeds from the offerings and the risks and trends affecting the business and these securities investments.

A. Background on Staking:

Coinbase began offering a staking program to U.S. investors around November 2019, utilizing the reward structure of the "proof of stake" consensus mechanism used by some blockchains to agree on which transactions are valid, update the blockchain accordingly, and reward participants with additional crypto assets;

B. Coinbase Provided Returns to Investors in the Coinbase Staking Program That Independent Staking Investors Might Not Have Access To

C. Coinbase Marketed the Coinbase Staking Program as an Investment Opportunity

D. Coinbase Profited from the Coinbase Staking Program

The revenue generated by Coinbase through the staking program is recognized by CGI and included in CGI's consolidated financial statements. CGI reported $275.5 million in revenue recognized for Coinbase blockchain rewards in its 2022 10-K annual report, primarily consisting of staking revenue. CGI also reported approximately $223 million in blockchain rewards revenue for 2021 and $10.5 million for 2020. These figures only include the total revenue generated by the Coinbase staking program, not net revenue, as CGI records the staking rewards paid to investors as "transaction fees." CGI has not disclosed the itemized transaction fees of Coinbase (including the staking rewards paid to investors) in its financial statements or elsewhere.

E. All Five Crypto Assets Applicable to the Coinbase Staking Program Are Securities

The five crypto assets include XTZ (Tezos), ATOM (Cosmos), ETH (Ethereum), ADA (Cardano), and SOL (Solana).

F. Coinbase Failed to Register Its Offers and Sales Related to the Coinbase Staking Program Because the Program Applies to Each of the Five Stakable Crypto Assets

The final judgment requested by the SEC from the court is as follows:

• To permanently enjoin Coinbase and other related parties from directly or indirectly violating the Securities Act;
• To require Coinbase to jointly and severally return all illegal gains obtained from violations of the Exchange Act and order Coinbase to return all illegal gains obtained from violations of the Securities Act along with pre-judgment interest;
• To require Coinbase to pay civil penalties under the Exchange Act and the Securities Act;
• To require the court to grant appropriate or necessary relief under the Exchange Act to protect the interests of investors.