Crypto Security Debate Goes To Court - Gatous News

Crypto Security Debate Goes to Court

WASHINGTON—Investors are asking the courts to decide an existential question for the cryptocurrency industry: whether digital tokens are, for legal purposes, more similar to stocks or to gold.

Attorneys for cryptocurrency trading platform Coinbase Global inc

COIN 4.02%

filed a motion this month to dismiss a class-action lawsuit arguing that 79 of the tokens listed on the firm’s platform are unregistered securities.

The group of Coinbase users is demanding reimbursement for trading fees and market losses and seeking to prevent the assets from continuing to trade on the platform. Among the assets targeted in the lawsuit are four of the 10 largest cryptocurrencies by market value: XRP, Cardano, Solana and Dogecoin.

Outside of enforcement actions, the Securities and Exchange Commission hasn’t indicated which cryptocurrencies it considers to be securities. But federal statutes passed in the 1930s deputize ordinary investors to help the SEC do its job, by giving buyers of unregistered securities the right to sue the seller for their money back.

The evaporation of some $1.5 trillion from cryptocurrency markets in the past six months could give investors a new incentive to test that power.

“The more money at stake, the higher the probability of litigation, and with the sharp downturn in crypto values, the incentives to litigate have turned up as sharply,” said Joseph Grundfest, a former SEC commissioner who teaches law at Stanford University.

Lawsuits related to cryptocurrencies are up this year. Investors have filed eight class-action lawsuits related to cryptocurrencies in 2022 so far, compared with 11 in all of 2021, according to a database maintained by Stanford University and Cornerstone Research.

US laws impose meticulous regulations and burdensome disclosure requirements on issuers and intermediaries that sell securities, a category of assets that includes stocks and bonds. They also create potentially crippling liabilities for anyone who skirts the law.

Cryptocurrency platforms have sought to minimize headaches by arguing that the tokens they list in the US are commodities, like gold, which have no full-time federal regulator.

For trading venues that allow US investors to buy and sell scores of digital tokens, the cost of getting it wrong is potentially catastrophic, industry lawyers say.

“If successful, plaintiffs would have this court effectively freeze the accounts of innocent [Coinbase] users who, by their own choice, transact with one another in these tokens,” Coinbase attorneys wrote in the motion to dismiss the case. “Other digital asset trading platforms would likely be compelled to do the same.”

Coinbase’s lawyers argue that its platform brings together buyers and sellers of cryptocurrencies, rather than transacting directly with users. For that reason, its lawyers argue, the firm wouldn’t be liable as a seller even if the assets on its platform were deemed to be securities.

Because cryptocurrency trading platforms aren’t supervised by regulators and clear transactions internally rather than on public blockchains, there is little transparency into how trades on Coinbase are executed, lawyers and SEC officials say. SEC Chairman Gary Gensler has alleged, without naming companies or going into further detail, that the platforms trade against their customers.

WSJ’s Dion Rabouin explains why Wall Street is now betting big on crypto and what that means for the new asset class and its future. Photo composite: Elizabeth Smelov

Coinbase’s lawyers also say the cryptocurrencies in the lawsuit aren’t securities.

But the issuer of one of the tokens featured in the Coinbase lawsuit, Block.One, agreed last year to pay $27.5 million to settle an investor lawsuit alleging that its EOS token was an unregistered security offering. EOS is still listed on Coinbase.

Another of the cryptocurrencies in the Coinbase lawsuit, XRP, is the focus of continuing SEC litigation and is no longer available to Coinbase users.

The company behind XRP, Ripple Labs Inc., is fighting the SEC suit and says the token isn’t a security. Block.One, and representatives for entities affiliated with Cardano, Solana and Dogecoin, didn’t immediately respond to a request for comment.

To determine whether an asset is a security, regulators and courts apply a four-part test developed in a 1946 Supreme Court ruling over orange groves. Known as the Howey test, it involves an investment of money in a common enterprise with an expectation of profits derived from the efforts of others.

Cryptocurrency advocates say that once a token’s underlying network becomes sufficiently decentralized, its value no longer depends on the efforts of an entrepreneur or manager, so it shouldn’t be considered a security. But the line is often fuzzy and the facts unclear.

Mr. Gensler has repeatedly said many of the assets traded on US crypto platforms are likely securities. He has urged the firms to register with the agency as regulated exchanges akin to Nasdaq or the New York Stock Exchange.

“They know that most of what they have on their platforms may well be securities,” Mr Gensler told reporters May 18. “They should move towards getting registered, or we’re going to be the cop on the beat and we’re going to bring the enforcement actions.”

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In an emailed response to questions about the lawsuit and liabilities it faces from potentially listing unregistered securities, a Coinbase spokesman said “this highlights the need for transparency, public-facing analysis and clear guidance from the SEC.” The firm said it conducts rigorous legal analysis when it lists a new cryptocurrency on its platform and is confident in its conclusions that none of the assets it offers are securities.

“We want to constructively engage on this issue but believe the SEC needs to make their thinking public so a meaningful debate can occur,” the spokesman said. “Clarity is critical.”

An SEC spokeswoman declined to comment.

Issuers of registered securities, such as publicly traded companies, must file standardized forms to the SEC that disclose any information that might be relevant to investors. This includes quarterly and annual earnings, key business operations and risks and the identities of top company officials, among other things. They can be held liable for major misstatements.

Information about cryptocurrency projects, by comparison, is typically disclosed in so-called white papers by authors who may or may not be using pseudonyms. The documents lack any formal structure or standardization, often making them difficult for unsophisticated readers to understand.

“You have a lot of investors who are inexperienced who don’t understand the risks of investing in securities generally,” said James Serritella, a plaintiffs’ lawyer in another lawsuit against a cryptocurrency platform. “You have issuers of tokens who have no restrictions either…and so it just invites fraud.”

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