Does the SEC have a case against Coinbase?

Coinbase (NASDAQ: COIN) has been planning to launch a loan product called Coinbase Lend for months. The company would take users’ cryptocurrency deposits and loan them to borrowers, securing their loans with other currencies such as Bitcoin. Depositors would earn interest on their holdings through the loans.

There is only a hiccup. Coinbase reported that the SEC had issued a Wells notice (an intention to sue) to the company regarding the Coinbase Lend program, alleging that the product constituted security and had to register as such.

Coinbase believes the SEC is far from the grassroots, and management has not been afraid to let the public know. Legal Director Paul Grewal released a blog post, and CEO Brian Armstrong let go Twitter.

The fight has big potential ramifications for Coinbase, as well as crypto investors in general.

Image source: Getty Images.

Is Coinbase Lend a security?

In Grewal’s blog post, he says the SEC uses case law from SEC c. Hto have to and Dreams vs. Ernst & Young, but the SEC refuses to provide details on their application. I’m not a lawyer, but let’s dive into the business.

In the Howey In this case, an investment contract is defined as “a contract, transaction or scheme by which a person invests his money in a joint venture and is made to expect profits only from the efforts of the promoter or a third party” .

From a layman’s perspective, Coinbase Lend certainly seems to fit the definition of an investment contract in the Howey Case. A person invests money in the Coinbase Lend program with the expectation of earning a return in the form of interest. The only way to earn that interest is for Coinbase to turn around and make money on that money by lending it to borrowers. These are solely the efforts of the promoter i.e. Coinbase.

The Dreams determined case that a ticket is a security based on four factors:

  1. The company sold the notes to raise capital and the buyers bought them for a profit in the form of interest.
  2. The tickets were offered and sold to a large segment of the public.
  3. The public reasonably perceived from the advertisements for the tickets that they were investments.
  4. There was no risk reduction factor that would make securities law enforcement unnecessary (like FDIC deposit insurance).

It can also be argued that it meets the definition of Dreams Case:

  1. Coinbase is raising capital to lend to others, and buyers expect to profit from the interest payments.
  2. Coinbase offers the product to everyone.
  3. It is seen as an investment.
  4. Check the Coinbase Lend disclosure: “Coinbase is not a bank. Your loaned crypto is not protected by FDIC or SIPC insurance.”

Again, I’m not a lawyer, but the SEC case looks pretty compelling.

The defense of Coinbase

Coinbase would like to point out that it is not the only player in town when it comes to crypto lending. “Other crypto companies have had lending products in the market for years, and new lending products continue to be launched as late as last month,” Grewal wrote in his blog post.

“If you don’t want this activity, just post your position, in writing, and apply it consistently across the industry,” Armstrong called the SEC on Twitter.

Although Armstrong argues that there are no official SEC guidelines, the defense is shaky at best. The idea that something shouldn’t be illegal just because other people have gotten away with it so far and there is no clear guideline is not a defense.

In addition, competing products have not been able to completely escape the law. BlockFi, for example, has been targeted by three states – New Jersey, Alabama and Texas – alleging that the crypto lending platform violates state securities laws.

What this means for investors

If Coinbase goes ahead with Lend and the SEC goes ahead with legal action, it could set a precedent that would prevent many other loan programs from working in the United States.

The reach of the SEC could even prevent decentralized finance (DeFi) protocols like Aave (CRYPTO: AAVE) and Compound (CRYPTO: COMP) to work. These companies’ tokens responded in kind after Coinbase announced the SEC’s Wells notice – the price of each fell sharply. However, DeFi protocols can be exempt from SEC oversight if they are decentralized enough, leading to another line of legal defense for Aave, Compound, and others.

The ability to take out secured loans is an essential part of DeFi and cryptocurrency investing. Crypto investors should pay close attention to the dispute as the ramifications could go far beyond Coinbase’s lending product.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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