Earlier this month, the Securities and Exchange Commission issued a warning to Coinbase Global Inc., the United States’ largest cryptocurrency exchange, based on the exchange’s announced plans to launch its new “Lend” product. The Lend product would allow eligible customers to earn interest on cryptocurrencies traded through Coinbase. In a Wells notice, however, the SEC informed Coinbase that it would pursue an enforcement action against the exchange if it proceeded with the launch.
The Wells notice referred Coinbase to two Supreme Court decisions as the basis of its review of Lend: S.E.C. v. W.J. Howey Co.[1] and Reves v. Ernst & Young.[2] Howey sets forth the criteria for determining whether notes constitute securities within the meaning of Section 3(a)(10) of the Exchange Act, while Reves sets forth similar criteria for reviewing financial instruments under the definition of security under Section 2(a)(1) of the Securities Act. Should a product fall under either definition for security, that product must be registered with the SEC and the platform offering the security would fall under SEC jurisdiction. Apparently, under the SEC’s review, Lend does in fact fall under at least one of these definitions.
Coinbase first publicized its receipt of the Wells notice in a blog post, where it also announced a month’s delay for the launch of Lend. The SEC had launched a formal investigation into Lend following the product’s announcement in June, and eventually reached the conclusion that Lend qualifies as a security. While Coinbase explained that it was attempting to work with the SEC towards a launch, they also disputed the agency’s conclusion. “Coinbase’s Lend program doesn’t qualify as a security,” Coinbase’s Chief Legal Officer Paul Grewal insisted. However, despite its earlier belligerence, Coinbase announced last week that it was dropping its plans to launch Lend.
Coinbase is not the only exchange to encounter regulatory scrutiny. State regulators from New Jersey, Alabama and Kentucky have each launched investigations and actions against Coinbase’s competitor, BlockFi Lending LLC. Accounts with BlockFi offer high yields on deposited cryptocurrencies, including yields with annual interest rates of over 7% for some cryptocurrencies. The firms behind these accounts carry no insurance and receive minimal federal regulation. Based on these concerns, regulators from New Jersey and Kentucky have both ordered BlockFi to stop offering some of their products in their states.
Cryptocurrency exchanges generally have recently received criticism from SEC Chair Gary Gensler. In an August 5th letter to Senator Elizabeth Warren, Gensler argued that “investors using these platforms are not adequately protected.” Many products offered by these exchanges legally qualify as securities, and yet have not been registered with the SEC. He also explained that exchanges are frequently used to sidestep public policy goals, being used for money laundering, tax evasion, and other illegal conduct.
Based on these early signs, cryptocurrency exchanges can likely expect heavier scrutiny in the future. If you have any questions or want to learn more, please contact James Pedersen (jpedersen@lowey.com). You can also follow Lowey Dannenberg on Twitter at @LoweyDannenberg for latest updates.
[1] S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946).
[2] Reves v. Ernst & Young, 494 U.S. 56 (1990).