The U.S.

crypto exchange Coinbase defended its business model in a

New York courtroom on Wednesday as it faces an existential lawsuit from
the Securities and Exchange Commission.

Arguing in front of Judge Katherine Polk Failla of the Southern District of

New York, Coinbase's lawyers sought to dismiss the SEC's lawsuit from
June 2023 that alleges the firm operates illegally by offering crypto trading
and staking services without first registering with the agency.

Failla spent five hours grilling each team of lawyers. Central to the lawsuit
is the debate over whether crypto assets are securities, and therefore
overseen by the SEC. The agency has long argued that the Howey test, a
Supreme Court framework established in 1946, ensures that most crypto
assets fall under existing securities law. Crypto advocates, including
Coinbase's lawyers, argue that Howey does not apply to the novel
structure of crypto assets and that the SEC is overreaching.

As the crypto industry clamors for regulatory clarity amid a bevy of

lawsuits from the SEC, Coinbase's court case represents a key pivot point
for the embattled sector, with a loss potentially crippling the ability of
many digital asset firms to operate in the U.S.

'Contractual undertaking'

Although cryptocurrencies have existed for 15 years, with Bitcoin created

in 2009, the SEC has dragged its feet on clarifying whether major crypto
assets like Ether and Solana fall under its regulatory remit. (The agency
has conceded that Bitcoin is a commodity.)

That changed in a series of lawsuits brought by the SEC against different

token issuers and intermediaries, starting with a 2020 case
against Ripple, the creator of XRP. After the broader collapse of the
crypto industry in 2022, the SEC ramped up its efforts, suing Terraform
Labs as well as exchanges including Coinbase, Binance, and Kraken.

In each of the lawsuits, the SEC made a similar argument: Howey

establishes that a security is an investment in a common enterprise with
the expectation of profit derived from the profit of others. The agency
argued that different cryptocurrencies satisfied the criteria, meaning that
many platforms selling the assets weren't operating in compliance.

At Wednesday's hearing, Patrick Costello, the SEC's assistant chief

litigation counsel, expanded on the agency's view that the tokens
themselves are not a security—but that when customers buy them on a
platform like Coinbase, they're investing in the network behind the tokens,
whose issuers often make promotional statements to boost their value.
"One cannot be separated from the other one," he said.

The question has already been contested in two other cases decided at
SDNY. In the Ripple lawsuit, Judge Analisa Torres found that XRP was an
investment contract only when sold to institutional investors but not in the
open market—secondary sales, like on Coinbase. Just a few weeks ago,
Judge Jed Rakoff disagreed, establishing a broader definition of crypto
asset securities in the SEC's lawsuit against Terraform Labs.

Led by William Savitt, the co-chair of litigation for Wachtell, Lipton, Rosen
& Katz, Coinbase's legal team seemed to take an even looser view than
Torres's ruling. He argued that the Howey test did not apply to
cryptocurrencies sold on Coinbase at all because there's no explicit
investment contract present—sales on secondary markets like Coinbase
are just trades between strangers.

Failla noted how the SEC's stance could push the boundaries of
securities into realms it doesn't intend to venture into, including
collectibles. The SEC sought to establish a "limiting principle," arguing
that investors buying tokens with the understanding that they were buying
into the ecosystem—driven by promotional materials—would create an
investment contract. Savitt argued that many commodities, such as gold,
have promotional statements, and what sets securities apart is the
"contractual undertaking that gives an interest in the business."

'Just out of luck'

While discussions around Howey ate up most of the hearing, the judge
also weighed two other debates. The first surrounded staking, a product
offered by Coinbase that allows users to deposit certain cryptocurrencies
to earn a yield.
As an SEC attorney explained, Coinbase is taking an established
technology—in this case, the staking rewards program endemic to certain
blockchains like Ethereum—and building an enterprise on top of it, which
they say constitutes an investment contract.

Coinbase's counsel disagreed, arguing that the tokens always belong to

the users, not Coinbase, and that the users are merely hiring Coinbase to
stake the tokens on their behalf.

A more contentious—and potentially consequential—debate hinged on

the Major Questions Doctrine, another Supreme Court precedent that
states Congress should not delegate issues of major political or economic
significance to agencies like the SEC. In other words, the SEC should not
create its own de facto legislation for consequential issues without explicit
instructions from Congress.

Failla referenced how Congress is actively weighing crypto legislation and

how Sen. Cynthia Lummis (R-Wyo.) even filed a brief arguing in favor of
Coinbase that questioned whether the judge would be stepping outside
her lane by creating precedence in the absence of congressional action.
The agency argued that crypto's relatively small imprint on financial
markets meant that the Major Questions Doctrine did not apply, and that
the SEC's duty is to apply existing securities laws to new financial
sectors.
In her questioning of Coinbase's lawyers, Fallia seemed hesitant to apply
the Major Questions Doctrine, alluding to the fact that it is rarely invoked
in decisions. "I worry that I am, in my own lane, doing exactly the thing
that you're arguing the Commission is doing here, which is to take power I
don't have to stop activity I shouldn't be stopping," she said. "I do have a
concern about not recognizing someone's authority to do something in
this space. The answer may be that I'm just out of luck until Congress
acts."

Acknowledging her reticence, Coinbase's counsel argued that the SEC

was effectively creating rules through enforcement actions against a
nascent industry. "The SEC should follow enforcement and rulemaking
actions that make sense of the statutory language and that does not twist
it upside down," Savitt said in his closing summation.

After five hours, Failla didn't issue a ruling from the bench. She asked for
more time to weigh the arguments.