Is This How Coinbase Will Argue Its Case Against the SEC?
Part II - The decision: crypto-assets mingling with their digital networks
In our previous post, we questioned the SEC’s premise during oral argument that there is no ecosystem behind Bitcoin. We argued that this is a false premise because it leads to the false conclusion that Bitcoin is worthless. More importantly, if that promise is false, then what is the difference between Bitcoin, which the SEC believes is not a security, and all the other coins? We hypothesized that Coinbase will likely argue along those lines.
The Court clearly didn’t believe that was a big problem, as its decision came out in favor of the SEC (we offered our reactions to the decision here.) In fact, the decision doesn’t even talk about Bitcoin specifically (it only mentions it twice, both in the context of factual background), but, arguably, it contains a similar logical fallacy that Coinbase will likely try to exploit…
Let’s revisit Paul Grewal’s X post again. Reminder - he is Coinbase’s Chief Legal Officer.
You may have noticed the phrases “independently consumed or used” and “intermingled with its digital network” in Grewal’s post. Why are they in quotation marks? These words came straight from Judge Failla’s decision:
Unlike in the transaction of commodities or collectibles (including the Beanie Babies discussed during the oral argument, see Jan. 17 Tr. 55:8-58:9), which may be independently consumed or used, a crypto-asset is necessarily intermingled with its digital network — a network without which no token can exist.
Let’s do some more logic, shall we? If we were Coinbase, we would argue along the following lines (Grewal also seems to be signaling a similar thought process):
A crypto-asset is necessarily intermingled with its digital network [Court statement]
Intermingled with digital network ←→ ecosystem [Inference from Court opinion]
Purchasing a crypto-asset → purchasing into crypto-asset’s ecosystem [Court statement]
Purchasing into crypto-asset’s ecosystem → crypto-asset is a security [Court conclusion]
Bitcoin is a crypto-asset [Factual statement that the SEC does not dispute]
(3) + (5) → Purchasing Bitcoin → purchasing into Bitcoin’s ecosystem [Logical inference]
(4) + (6) Purchasing into Bitcoin’s ecosystem → Bitcoin is a security [Logical inference]
Bitcoin is not a security [SEC position]
(7) + (8) → CONTRADICTION
To be clear… Coinbase would not argue that Bitcoin is a security. Coinbase would simply take the Court’s argument to its logical conclusion, which would imply that Bitcoin is a security. Coinbase would then point out that the conclusion that Bitcoin is a security contradicts the SEC’s official position that it is not; therefore the Court’s reasoning that led to the transactions in those 13 crypto-assets constituting investment contracts does not hold up and the decision should be reversed on those grounds. This is what Paul Grewal is alluding to.
Law, ultimately, is an exercise in logic, supported by authorities (cases, statutes and other authorities). In this case, a standard application of logic seems to have eluded the court. By trying to distinguish collectibles and commodities from crypto-assets, the Court opined that Beanie Babies are not securities because they can be “independently consumed and used” and tried to distinguish crypto-assets by arguing that a crypto-asset is “intermingled with its digital network.”
In essence, feeling the need to distinguish commodities and collectibles from crypto-assets, the Court seems to be hanging its hat on the “common enterprise” prong of the Howey test (siding with the SEC). We don’t think that’s the limiting principle the Court should use; rather, it is the “expectation of profits” prong. We will elaborate on that idea in our next couple of posts. This post is about Bitcoin, though, so let us say this: By invoking the incorrect Howey prong, the Court inadvertently sucks Bitcoin into the orbit of its argument, creating a weakness by way of developing a contradiction (Do Bitcoin purchases constitute security transactions or not?)
If Coinbase argues this way, and there is no reason to believe why they wouldn’t, how strong is this argument? In the hands of a critical thinker, it is likely fatal. That’s why we said:
The SEC could still pivot, and potentially start winning all these cases. They probably won’t, and, as a result, they might win some battles (they could survive motions to dismiss) but they might lose the war.
You might wonder: Wait, we thought you agreed with Judge Failla’s decision. Now, you seem to be saying that Coinbase has a point. What gives?
What is happening here is that the SEC’s interpretation of the Howey test is incomplete, and they committed themselves to the position that Bitcoin is not a security based on that incomplete interpretation. It will be very difficult for the SEC to walk that back. The conundrum lies with the fact that by taking the position that Bitcoin is not a security, they created their own vulnerability. The SEC seems to realize that they have to differentiate Bitcoin somehow, and since they position the existence of an “ecosystem” (whatever that means) as a necessary condition for a transaction to constitute an investment contract, and therefore a security, they feel forced to claim that there is no ecosystem behind Bitcoin. As a result, we expect that Coinbase will walk right through the open door the SEC and the Court left for them, red carpet and all.
So, then, why do we still believe that the transactions on Coinbase constitute investment contracts? The problem is that Coinbase’s interpretation of the Howey test is also incomplete. They seem to have a good argument here only because both sides are operating on a faulty foundation. Once Howey is properly refined, all those issues go away!
This matter will likely go to the Supreme Court, and the SEC will be proven right eventually, but the winning argument won’t be the one they are making right now.