As oral argument in SEC v. Coinbase approaches (scheduled for January 17, 2024), it’s crucial to note our active involvement in the case through the submission of an amicus brief, accessible here. Despite our efforts, our request to participate in oral argument was regrettably denied by the Court.
What will Coinbase’s central argument be in this legal battle? While predicting legal strategies can be a futile effort, a glimpse into what Coinbase has been circulating suggests a compelling narrative centered around a slightly unexpected analogy: baseball cards.
Here is a sample collection:
This inclination is supported by clue #1, as provided by Paul Grewal, Coinbase’s Chief Legal Officer:
Clue #2 derives from another X post by Paul Grewal:
Perhaps even more important than these posts, which we will call clue #3, was a paragraph within Coinbase’s opening brief (PDF) suggesting that baseball cards and like objects may play a central role in its argument:
So for example: one can invest in a baseball or other trading card company, through an instrument that imposes obligations on the company, and that will be a security. Or one can buy baseball cards on the open market, hoping they appreciate in value, and one will have bought a commodity. That remains true even if the company makes representations about plans to create a premier card trading platform, to drive up the value of the cards it sells. Those representations can’t turn baseball cards into securities. Baseball cards are not “shares in the [baseball card] enterprise.” Howey, 328 U.S. at 299.
And:
On Coinbase’s secondary-market exchange and through Prime, there is no investment of money coupled with a promise of future delivery of anything. There is an asset sale. That’s it. It is akin to the sale of a parcel of land, the value of which may fluctuate after the sale. Or a condo in a new development. Or an American Girl Doll, or a Beanie Baby, or a baseball card.
Collectively, it is reasonable to infer that Coinbase is strategically aligning itself with the concept of baseball cards. What could that argument look like? In what follows, we first present, in the section adjacent to the vertical blue bar, how we think Coinbase could argue it. Please bear in mind that this is a hypothetical exercise. After presenting that hypothetical argument in short form, we also offer our commentary.
Step 1 - Leverage from History
Hypothetical Coinbase argument: People have been buying and selling assets such as baseball cards and Beanie Babies for a long time. Nobody has ever suggested that any of these assets are securities. In fact, Chair Gary Gensler himself admitted that these types of assets are not securities.
Chairman Gensler made this admission, with respect to Pokemon cards at least, when he was questioned by Rep. Torres during a recent Congressional hearing. We covered it in detail in our September post on investment contracts. Consider this relevant excerpt from that hearing, which we also cited in our September post:
REP. TORRES: Suppose I would have purchased a Pokémon card. Would doing so constitute a security transaction?
MR. GENSLER: You could purchase a Pokémon card. I don’t know what the context is, but if you’re just purchasing a Pokémon card…
REP. TORRES: If I purchase a Pokémon card, is that a security transaction?
MR. GENSLER: That’s not as secure…
Is Chair Gensler’s admission fatal to the SEC’s case? No, it isn’t (we’ll explain why below), but it does create a hole in the SEC's argument that Coinbase will undoubtedly attempt to exploit.
Step 2 - Establish Equivalency (and Rule out Technology)
Hypothetical Coinbase argument: If Pokemon cards are not securities, then neither are baseball cards. And, if baseball cards are not securities, then neither are crypto tokens. Fundamentally, they are all very similar assets. The fact that the crypto tokens are delivered digitally does not make a difference; that’s just the form of delivery. Furthermore, Chair Gensler has already admitted that the SEC is technology-neutral.
When did Gary Gensler say the SEC is technology-neutral? In the very same Congressional hearing that we mentioned above (full hearing). In fact, Rep. Torres argued along these lines - here is that excerpt:
REP. TORRES: Okay, if I were to purchase a tokenized Pokémon card on a digital exchange via a blockchain? Is that a security transaction?
MR. GENSLER: I’d have to know more.
REP. TORRES: Okay, so for you the process of tokenization is what transforms a non-security transaction into a security transaction?
MR. GENSLER: If the investing public…
REP. TORRES: I thought you were technology-neutral.
MR. GENSLER: If the investing public is anticipating profits based upon the efforts of others and they’re exchanging fines. That’s the core of…
REP. TORRES: I see my time has expired.
The concept of precedent is a double-edged sword. On one hand, it can result in fairness and efficiency. On the other hand, when applied incorrectly, it might allow a newcomer to hide behind an alleged similarity and bypass the law.
We do agree that the physical-to-digital conversion, per se, does not turn something that was previously a non-security into a security. So, what else is left for the SEC to argue? The SEC can’t credibly walk back Gensler’s statements, but it doesn’t have to. One principled counterargument could be to attack the second step and argue against the alleged equivalency. Below, we elaborate on that angle using the three objects Coinbase cited in its brief: American Girl dolls, baseball cards and Beanie Babies.
American Girl Dolls
This particular example appears to be a weak point for Coinbase. Drawing from the perspective of many parents, including this author’s own experience having a daughter, American Girl dolls are typically not purchased with the intent to resell them for a profit. One common scenario involves parents taking their child(ren) on a playdate at one of the American Girl stores, perhaps the American Girl store on Michigan Avenue, where they make their choices for their favorite American Girl doll. While it is acknowledged that individual experiences may vary, and there could indeed be individuals who purchase American Girls dolls with a profit motive, it seems unlikely that the majority of people are purchasing these dolls to flip them. Thus, we don't think Coinbase will emphasize this particular example during the hearings. They may prefer to distance themselves from this weak analogy.
Baseball Cards
Are baseball cards a better analogy than American Girl dolls? This is the question that matters: Are individuals purchasing baseball cards primarily because they are collectors or do they do so with the expectation of an increase in future value?
The answer lies somewhere on a spectrum, with a blend of collector sentiment and/or a speculation motive. While the exact distribution may be uncertain–whether it leans more towards 30%/70%, 50%/50% or 70%/30% – it seems plausible that a larger portion of baseball card buyers are motivated by profit, relative to those acquiring American Girl dolls.
Adding another layer of complexity is the ongoing legal case concerning basketball NFTs, Friel v. Dapper Labs, Inc., which notably withstood a motion to dismiss (PDF), introducing a pertinent dimension to the evolving legal landscape.
Beanie Babies
Beanie Babies can be subjected to the exact same question: Are individuals purchasing Beanie Babies primarily because they are collectors or do they do so with the expectation of an increase in future value?
The book we are currently reading is The Great Beanie Baby Bubble. It is undeniable that profit played a central role, at least during a certain period. For example, this was the perspective of a former commodity trader who was purchasing quite a few Beanie Babies at the time:
“It’s not different than any other kind of investment -- the stock market or the commodities market.”
Ty Warner, the creator of Beanie Babies, strongly disapproved of the profit-centric focus. The book further underscores Warner’s disdain for Beanie Babies being turned into speculative tools:
Warner saw the experts as overhyping his product beyond the benefits that it could reasonably be expected to produce -- especially when the price guides exaggerated current market prices, as they often did. Warner was focused on the long term, and the rise of the speculative market was at odds with the longevity he sought. He once said that he wanted the Ty brand to be the Coca-Cola of collectibles, and even as the fad was making him rich, its ephemeral nature grated on him.
The passage, particularly the phrase, “...beyond the benefits that it could reasonably be expected to produce…” intricately parallels the “expectation of profits” prong of the Howey test, doesn’t it? Did a sufficient majority purchase Beanie Babies with a profit motive? If so, would that potentially make them securities? If yes, what are we supposed to do with the fact that the percentage of people who purchased Beanie Babies with the expectation of profits may have varied wildly over time?
One must turn to Howey to put all these considerations into context.
The Third Prong of Howey
The “expectation of profits” prong of Howey demands a yes or no answer, but as it should be clear from the analysis provided above, sometimes the answer truly lies on a spectrum, and that is precisely the problem. Where exactly does a purchase transaction cross into the domain of being a security?
In SEC v. LBRY, Inc., the Court recognized this tension. The following exchange from the hearing transcript is illuminating:
THE COURT: What's your take -- so I think LBRY's counsel did a good job of drawing my attention to Judge Selya's discussion of Forman and Joiner, and they cite in their brief cases that deal with their expectation of other cases, but they talk about you don't have to prove it solely for investment purposes.
So if you don't have to prove it solely, what is the test, and what does the SEC say is the test for expectation of profit? It's not solely. You would I'm sure agree it's not solely because Judge Selya says it's not solely.
Do you agree that it's principally? Do you agree that -- do you have a view that there's some other test? What is it that you say is the legal refinement of Howey and Joiner and Forman?
Then, the Court honed in on the spectrum issue:
But then you still have to ask in a mixed motive case if some acquirers are acquiring for purely consumptive and others are acquiring purely for investment, what is the test by which a judge evaluates that kind of a case, which I don't think any of the cases I've seen have really evaluated in detail those kinds of -- that kind of problem, and that's what we seem to have here.
I think it's undeniable that people are acquiring LBC for investment reasons. I think it's undeniable that people are acquiring LBC for consumptive reasons. How do I determine in a case like that whether something is acquired -- a reasonable investor considering the total mix and not looking at any one factor determine -- where some investors are acquiring for consumptive and some investors are acquiring for investment, how do I determine whether in that case it meets the first component of the third element of the Howey test? (emphasis added)
That is the real problem. To be clear, what the Court refers to as “the first component of the third element” is the “expectation of profits” prong of Howey (the third prong). We believe Howey should be interpreted to have four prongs (and that’s critical), not three, but that’s for another day.
The Court was not getting a clear answer, so the Judge kept asking:
I'm trying to have you help me formulate the correct standard in what you might call a mixed case where investors are acquiring -- or people are acquiring the digital asset some for consumptive reasons, some for investment reasons, some mixed investment and consumptive reasons. At what point does the expectation of profits test justify a conclusion that that component of the test is satisfied? What formulation? What language do you think I ought to use to describe that component of the test? (emphasis added)
Bingo! This is the measurement problem. It’s a real issue. The Judge, rightfully, kept pressing:
THE COURT: But if a reasonable acquirer -- let's say it came out that 70 percent of the people that bought LBC -- we actually dragged every LBC purchaser into court, put them under oath, asked them, why did you buy it, what's your evidence, or we had definitive -- apparently there is no evidence that definitively shows which are consumptive uses, but if we had all of that and we could nail down absolutely and the conclusion I came to at the end is 75 percent of LBCs were used and bought for consumptive purposes, people realized that there are also promotion of this for investment, and 25 percent were buying because of investment, would that make it expectation of profits?
MR. JONES: Your Honor, I want to suggest to the Court that that would be a tough test to both implement and --
THE COURT: What if we flipped it and it was 25 percent wanted to use it for consumptive uses and 75 percent didn't? Would that be a -- they wanted to use it for investment first. Would that be a security, meet the component of that test?
MR. JONES: Your Honor, I think in neither case does the ratio actually help the Court or a securities issuer to determine whether it is a security or not. That is why the economic reality -- and it's not just labels have to be issued and all that. Part of the economic realities test is what's really going on with this thing. When you buy it, when it is a transaction in commerce, what's happening?
So, the SEC did not like the ratio analysis. It is true that this would be difficult to measure. But it doesn’t need to be measured exactly. We don’t agree that having that measurement problem get in the way of applying Howey properly makes sense.
Equally importantly, arguing that the ratio is different in baseball cards vs. crypto tokens may be the only way that the SEC doesn’t lose against Coinbase.
Again, one does not need to measure the location on the spectrum exactly, certainly not at this stage when the decision that needs to be made is whether or not to dismiss. All the SEC needs to do is to make a plausible argument, and we strongly believe one exists, that the intent of crypto token purchasers skews substantially more to the profit side of the spectrum.
We made that point in our amicus brief:
If the vast majority of the gold buyers buy it for consumptive purposes, a Howey analysis would likely conclude that gold is not an investment contract. A similar argument would disqualify American Girl Dolls, baseball cards, and, notwithstanding the fact that speculative intent may have dominated for a limited period of time, Beanie Babies. The same principle, of course, shall apply to cryptocurrencies, but it is not sufficient to assert that the predominant use of crypto tokens is consumptive, that assertion should be proven out by facts, and NFI is not aware of such an analysis being produced for any token. Anecdotal evidence won’t suffice.
So, crypto tokens are plausibly different from all these other assets in a critical way, which is the dominance of the expectation of profits.
By the same token (no pun intended), it is also possible that purchases of the physical version of baseball cards don’t constitute security transactions and the digital versions very well may, because the motive of the purchasers could be substantially different There is nothing in Howey that precludes that possibility. In that case, it would not be the technology that flips it into a security, but answering the “expectation of profits” question differently.
What About the Rest of Howey?
Now, you might say, even if one concedes on the “expectation of profits” prong, that doesn’t prove that crypto tokens are securities. One could argue that the analysis has to exhaust all of the Howey prongs, and not stop if the third prong yields a yes answer.
We fully agree. That said, we don’t think all of the Howey prongs are applicable in this case. We believe that a modified Howey test is the lens the Court should look through to properly resolve this case.
What is the importance of the modified Howey test? We strongly believe it is the legal refinement that is sorely needed. We only briefly mentioned it in our Coinbase amicus, but started building it in another amicus brief we submitted, in SEC v. Binance. We were hoping to incorporate that analysis into the oral argument segment, but unfortunately, we were denied participation by the Court. We look forward to other avenues in which to advocate for it.
We are of the view that the SEC’s strongest path to a victory runs through the ratio analysis with respect to the expectation of profits prong described above as well as a modified Howey analysis, which is admittedly novel, but has extremely strong foundations in, and alignment to finance principles. We think the SEC needs the former to survive the dismissal stage, and the latter to ultimately win. They seem to have rejected the former (the ratio argument) in another case. The latter (the modified Howey) would have been articulated verbally to the Court, had we been allowed to participate. In the absence of both, one possible path is that the case may get dismissed, which would be not just another loss for the SEC, but a huge loss for investor protection. We will continue to do our part and we can only hope it makes a difference.