On Wednesday, March 22, 2023, the Securities and Exchange Commission (“SEC”) issued a Wells notice to Coinbase, stating its intent to recommend that the SEC commence an enforcement action for purported violations of the Securities Exchange Act of 1934 (“Exchange Act”) and the Securities Act of 1933 (“Securities Act”). Specifically, the SEC stated that allegations will include purported violations of Sections 5, 15(a) and 17A of the Exchange Act, and Sections 5(a) and 5(c) of the Securities Act, and may seek civil injunctions, a cease-and-desist order, disgorgement, pre-judgment interest, and civil money penalties. A Wells notice is not a statutory obligation, but is standard practice for regulators such as the SEC and FINRA prior to commencing an enforcement proceeding. A Wells notice comes at the end of an investigation and gives the target of the investigation an opportunity to rebut the allegations via a memorandum, brief, or even a video as to why the SEC Commissioners should not approve the SEC enforcement staff’s recommendation. Wells notices frequently – but not always – result in charges, and not all potential issues raised in or prior to the notice become a part of an eventual enforcement action. Coinbase is the largest digital asset exchange, and the only publicly traded digital asset exchange in the United States.
The SEC notice to Coinbase comes on the heels of recent doubt cast by courts around the country about the SEC’s vague and inconsistent treatment of digital assets, including a recent determination by U.S. Bankruptcy Court Judge Michael Wiles who said he was “absolutely shocked” by SEC claims – made in connection with its effort to stop Binance.US from purchasing the assets of now defunct crypto lender Voyager – that it “might have an issue” with Voyager’s token (VGX), which it represented could constitute an unregistered security. Judge Wiles approved the sale over the SEC’s “vague” objections. The case is Voyager Digital Holdings, Inc., et al.; Case No. 22-10943, pending in the United States Bankruptcy Court for the Southern District of New York.
A similar instance involves challenges asserted by the SEC to Grayscale’s exchange-traded fund application, before the District of Columbia Circuit Court of Appeals in Washington, DC, where the Court grilled the SEC on what it viewed as inconsistent treatment by the SEC for its rejection of Grayscale’s spot market-based bitcoin ETF, while otherwise permitting futures-based bitcoin ETFs. The panel of three judges, Chief Judge Sri Srinivasan and Judges Neomi Rao and Harry Edwards, appeared skeptical of the SEC’s view that a spot market-based bitcoin ETF was somehow more susceptible to manipulation. The case is Grayscale Investments LLC v. SEC, Case No. 22-1142, pending in the U.S. Court of Appeals for the District of Columbia.
Although the Wells notice is purposely vague, Coinbase in a recent filing stated that it believes the potential enforcement action relates to aspects of its spot market, staking service Coinbase Earn, Coinbase Prime, and Coinbase Wallet. The SEC has been using enforcement to assert control over the crypto industry, largely targeting individuals, small companies, and settling with disinterested celebrity “promoters” to bring the burgeoning space within its purview. Coinbase has consistently sought crypto industry rule making and clarity from legislators and regulators, including a July 2022 petition to the SEC “requesting that the Commission propose and adopt rules to govern the regulation of securities that are offered and traded via digitally native methods, including potential rules to identify which digital assets are securities.” In February 2023, the SEC settled with Coinbase’s rival Kraken over its staking program and issued a Wells notice to Paxos Trust Co. alleging the sale of unregistered securities in connection with its stablecoin (Binance USD). Coinbase has maintained that the tokens listed on its exchange aren’t securities and the company’s staking product is different than that previously offered by Kraken. Now, it seems Coinbase may be forced to address these issues before the Court.
Coinbase has until March 29, 2023 to notify the SEC whether it intends to rebut the SEC’s findings that securities laws were likely violated, and submit a Wells submission which would be due by April 5, 2023. While a Wells notice does not always necessarily lead to an enforcement action – and certainly does not mean any actual violation occurred – a response by Coinbase is unlikely to deter any internal decisions already made by the SEC’s Enforcement Division about its intended next steps.