Op-ed: Why the SEC should stay away from crypto (Part III)

This article is the final part of a three-part series. We suggest reading parts one and two for context.

As The Wall Street Journal highlighted in a recent article, Coinbase’s argument around their successful IPO presents a “novel” defense in court. As most of us are aware, when Coinbase went public, it had already listed several of the “problematic” tokens listed in the SEC lawsuit, yet the SEC greenlighted its IPO all the same.

In a Bloomberg op-ed, Matt Levine argued that the SEC’s role in approving public listings does not look into a company’s business model. The SEC assesses the disclosed risks of the business model, not whether any securities the business offers customers are done so legally, according to Levine.

Interestingly, however, Levine highlighted that “Coinbase went public three days before Gensler was sworn in at the SEC; he was just a bit too late to stop the IPO,” suggesting the current SEC Chair may not have approved the listing had it been delayed until he took over.

Furthermore, in relation to the “disclosed risks” to investors. Coinbase mentions the word “securities” 821 times in its S1 filing to the SEC (after removing mentions of “securities act” from the results.) In comparison, popular crypto terms such as NFT, token, staking, and even cryptocurrency are mentioned just 1, 41, 36, and 3 times, respectively.

How will Coinbase defend the lawsuit?

In light of these revelations, we find ourselves at a critical juncture where Coinbase’s novel defense hinges on the letter of the law, notably the Securities Act of 1933 (the ‘33 Act) and the Securities Exchange Act of 1934 (the ‘34 Act), and possible applications in court.

The ‘33 Act and the ‘34 Act are significant pieces of U.S. legislation enacted to regulate the primary and secondary trading of securities such as stocks, bonds, and debentures. They were enacted after the stock market crash of 1929 and, in addition to establishing federally mandated registration and reporting requirements, created the SEC.

CryptoSlate has been embracing AI technologies for years. However, the ability to use LLMs as a co-pilot for research is really changing the way we look at analysis. I am by no means a legal professional, yet, complex language models now make it possible for me to have the equivalent of a paralegal to aid in my research, and the results are, at the very least, intellectually fascinating.

With the stakes higher than ever, I examined the potential avenues of defense surrounding Coinbase’s successful IPO and its implications on the ongoing lawsuit. I used OpenAI’s GPT-4 API to analyze Rule 144 to identify any potential language that could benefit Coinbase in a novel defense against the SEC. The AI produced several potential defenses and some areas that may cause issues for Coinbase.

Rule 144 Safe Harbor: A Potential Defense

One possible approach lies in the SEC Securities Act of 1933 Section 230.144 (Rule 144). Coinbase could attempt to invoke Rule 144 Safe Harbor, which establishes a safe harbor from the definition of “underwriter,” according to a Large Language Model (LLM) analysis.

A key defense strategy for Coinbase could be claiming Rule 144 Safe Harbor, which establishes a safe harbor from the definition of “underwriter.” If Coinbase satisfies the conditions of Rule 144, it would not be deemed engaged in a distribution of securities and, therefore, not an underwriter under Section 2(a)(11). This could enable Coinbase to claim the Section 4(1) exemption for transactions by persons other than issuers, underwriters, or dealers and potentially defend against the SEC’s lawsuit.

To claim the Rule 144 Safe Harbor, Coinbase must demonstrate compliance with all applicable conditions of Rule 144. If successful, the company may avoid being considered engaged in a distribution and ensure the purchaser receives non-restricted securities.

In order to properly assess the legal landscape at play here, David Lopez-Kurtz, attorney at Chicago-based Croke Fairchild Duarte & Beres LLC and founder and CEO of BSL Group, a legal operations, compliance, and technology company, gave his time to co-author part of this op-ed. He commented:

The issue with trying to claim 144 as an exemption for secondary transactions will be these conditions:

• Holding Period: For restricted securities, the security holder must hold them for a minimum period, usually six months or one year, depending on the issuing company’s reporting status with the SEC.

• Public Information: Adequate current public information about the issuing company must be available to the public.

• Trading Volume: For affiliates, the number of equity securities that may be sold during any three-month period cannot exceed the greater of 1% of the outstanding shares of the same class being sold, or if the class is listed on a stock exchange, the greater of 1% or the average reported weekly trading volume during the four weeks preceding the filing of a notice of sale on Form 144.

• Ordinary Brokerage Transactions: The sales must be handled in all respects as routine trading transactions, and brokers may not receive more than a normal commission.

• Notice: If the sale involves more than 5,000 shares or the aggregate dollar amount is greater than $50,000 in any three-month period, the seller must file a notice with the SEC on Form 144.

• Manner of Sale: For equity securities, the sales must be conducted through a broker in an unsolicited “brokers’ transaction,” directly to a market maker, or via a riskless principal transaction.

Sales to Qualified Institutional Buyers

Another potential defense for Coinbase involves the sale of securities to qualified institutional buyers (QIBs). If the company can prove that the securities in question were sold exclusively to qualified institutional buyers or purchasers that the seller reasonably believed to be qualified institutional buyers, the sale may be exempted under Rule 144A.

Lopez-Kurtz added his thoughts on this approach;

This, however, is likely unhelpful because of the limited population of QIBs. The definition of a QIB includes:

• A corporation or entity that manages at least $100 million in securities from issuers not affiliated with the entity.

• A registered broker-dealer owning and investing, on a discretionary basis, at least $10 million in securities of issuers not affiliated with the broker-dealer.

• A bank or savings and loan institution with a net worth exceeding $25 million.

• An entity, all of the equity owners of which are QIBs.

This classification allows these entities to trade private placement securities without registering the trades with the SEC (as they are considered to have sufficient knowledge and expertise to understand and handle the associated risks), but as can be seen above, is unlikely to include any significant percentage of Coinbase’s users by headcount.

Reasonable Steps to Ensure Purchaser Awareness

Coinbase could also argue that it took reasonable steps to ensure the purchaser was aware of the exemptions it relied on, as mentioned in the SEC Securities Act. If the company can demonstrate this, it could be used as a defense against the SEC’s claim of selling unregistered securities. However, Lopez-Kurtz remarked that “insufficient risk disclosure was called out in the complaint as something that Coinbase had accountability for.”

Other Defenses and Limitations

It is crucial to note that the text of Rule 144 does not provide information suggesting an approved IPO protects the company from selling unregistered securities. However, Lopez-Kurtz commented, “Rule 144 has nothing to do with the IPO for purposes of Coinbase’s position or defense.” Moreover, having an approved IPO does not protect the company from being sued for selling unregistered securities.

Therefore, while the SEC Securities Act Rule 144 provides some potential defenses for Coinbase, the company’s path to victory against the SEC lawsuit remains uncertain. By carefully analyzing different aspects of Rule 144, Coinbase could potentially develop a novel defense strategy that ultimately protects its interests and ensures the continued growth of the cryptocurrency industry.

However, the above analysis was done in the specific silo of the language of the Securities Act of 1933, and it is essential to recognize factors outside the Securities Act, such as other legal precedents, legislation, regulatory developments, and the perspective of legal professionals.

On the Matter of Registration

Lopez-Kurtz highlighted that perhaps the stronger argument will focus on the fact that the SEC allowed Coinbase to go public.

According to the SEC, “Declaring effective a Form S-1 registration statement does not constitute an SEC or staff opinion on or endorsement of, the legality of an issuer’s underlying business.”

This, however, according to Lopez-Kurtz, this seems to be an attempt to address head-on the very reasonable question: 

“If the SEC believed that Coinbase was actively acting as an unregistered exchange, broker-dealer, and clearing agent, how is it possible that the registration could be approved without, at the very least, requiring a disclosure that Coinbase was actively violating U.S. securities law? The SEC has pursued enforcement actions against issuers for making hedged ‘maybe’ disclosures while omitting reference to active risks to the issuer’s business. The SEC ostensibly knew that it would pursue this enforcement action, but at the same time decided that such very real risk to Coinbase and its investors was not worth disclosing.”

So, what does the registration process look like? Would the SEC necessarily see this sort of risk, and should they have forced Coinbase to disclose it?

In order to register securities with the SEC, issuers must file a registration statement with the SEC, typically by filing Form S-1 (like Coinbase did). Form S-1 Registration Statement consists of two parts: (1) a “prospectus,” which is provided to potential investors; and (2) supplemental information not provided to investors but which is publicly available.

The prospectus contains financial statements and narrative disclosures about the company and the securities offering being registered. The prospectus is meant to disclose all relevant, material information for a reasonable investor to make an investment decision. 

After filing, Form S-1 is subject to SEC review and comment. The statement is typically reviewed by an SEC attorney and an SEC staff accountant to ensure that the issuer has made all required disclosures. It is true that the SEC does not determine the merits of the company’s business, management, or prospects or the merit or value of the securities offering being registered – the scope of the review is limited to determining whether the disclosures made by the company comply with applicable securities laws.

After the SEC completes its review, it then sends comments to the company. The issuer then files an amendment to Form S-1 and a response letter to the SEC’s comments. Then, once the SEC has determined that all of its comments have been sufficiently answered, the Form S-1 is declared “effective,” and the company can sell its registered securities.

So, how is it possible for the SEC to have simultaneously held the position that Coinbase was fundamentally and repeatedly violating U.S. securities law, as well as the position that Coinbase had sufficiently disclosed all relevant material risks to investors on Form S-1?

It may well now be for the courts to decide.

Appendix

The AI co-pilot analysis with references to the specific sections of Rule 144 used in the above analysis is stated below. The model was programmed to analyze each section of Rule 144 for relevance to the SEC vs. Coinbase lawsuit.

Defense: Rule 144 Safe Harbor
Reference: Section 230.144 – Rule 144 Safe Harbor from the definition of “underwriter”

Explanation: The company can argue that it satisfied the conditions of Rule 144, which establishes a safe harbor from the definition of “underwriter.” By meeting these conditions, the company would be deemed not to be engaged in a distribution of the securities and, therefore, not an underwriter for the purposes of Section 2(a)(11). This would enable the company to claim the Section 4(1) exemption for transactions by persons other than issuers, underwriters, or dealers and potentially defend against the SEC’s lawsuit for selling unregistered securities.

Defense: Rule 144 Safe Harbor
Reference: The applicable conditions of Rule 144

Explanation: If the company can demonstrate that the sale of unregistered securities complied with all the applicable conditions of Rule 144, it may claim the safe harbor provided by Rule 144 to avoid being considered engaged in a distribution and the purchaser receiving non-restricted securities.

Defense: Rule 144 Safe Harbor
Reference: §230.144(c)(1)

Explanation: The company could argue that the sales of unregistered securities fall under the Rule 144 Safe Harbor provisions, as the company has been subject to the reporting requirements of section 13 or 15(d) of the Exchange Act for at least 90 days before the sale and filed all required reports during the preceding 12 months.

No Defense
Reference: §230.144 (d)(1)(I)

Explanation: The approved IPO does not protect the company from SEC enforcement action for selling unregistered securities if they have not complied with the holding period requirements outlined for restricted securities.

Defense: Holding company formation
Reference: §230.144(d)(3)(ix)

Explanation: If the securities were acquired as part of a holding company formation following the conditions specified in paragraphs (A), (B), and (C), then the holding period for these securities will be the same as the holding period for the predecessor issuer’s securities. This defense could be used if the company can prove that the unregistered securities were part of such a transaction and that all the specified conditions were met.

Defense: Issuance of employee stock options
Reference: (e) Limitation on amount of securities sold

Explanation: If the unregistered securities were issued in the form of employee stock options and did not create any investment risk to the holder, this could be a potential defense against the SEC’s allegations, as these securities would be deemed acquired at the time the options or warrants are exercised.

Defense: Sales of securities within the limitations of Rule 144
Reference: §230.144(e)(3)(ii)

Explanation: If the unregistered securities were sold within the specified limits of Rule 144, they may be exempt from registration requirements. The company can defend itself by demonstrating that the sales complied with the conditions outlined in this section.

No Defense
Reference: Paragraph (e)(1) and (2)

Explanation: The text does not provide information about whether the unregistered securities were sold in a manner that would be exempt from registration requirements, and an approved IPO does not protect the company from liability for selling unregistered securities.

No Defense
Reference: Rule 144(h) Notice of proposed sale
Explanation: The information provided does not indicate the company followed the proper procedures, such as filing Form 144 or providing notice of the proposed sale, which is required for certain amounts of securities sold. Without evidence of compliance with these rules, the company cannot claim a defense based on the approved IPO.

No Defense
Reference: Section 230.144A – Preliminary Notes 1, 3, and 6

Explanation: The text refers to section 230.144A, which relates solely to the application of section 5 of the Act, and does not provide an exemption from the registration requirements of the Act if a transaction or series of transactions is part of a plan or scheme to evade those provisions. Additionally, securities acquired in a transaction made pursuant to the provisions of this section are deemed to be restricted securities. Therefore, an approved IPO does not protect the company from the SEC’s claim of selling unregistered securities.

Defense: Securities sold to qualified institutional buyers
Reference: Section (a)(1)(i)(A) through (J)

Explanation: The company may argue that the securities in question were sold to qualified institutional buyers, which are exempt from the registration requirements of the Act.

No Defense
Reference: buyer status under Rule 144A(a)(1)(i)(J)

Explanation: The text does not provide any information about the company’s IPO approval protecting it from selling unregistered securities. The information only pertains to the buyer status and qualified institutional buyers, which is not relevant to the company’s defense against SEC’s lawsuit.

Defense: Securities sold only to qualified institutional buyers
Reference: §230.144A (d)(1)

Explanation: If the securities in question were sold only to qualified institutional buyers or purchasers that the seller reasonably believed to be qualified institutional buyers, the sale may be exempted under this section.

Defense: Reasonable steps taken to ensure purchaser awareness
Reference: the information stating “any person acting on its behalf takes reasonable steps to ensure that the purchaser is aware that the seller may rely on the exemption from the provisions of section 5 of the Act provided by this section;”

Explanation: If the company can demonstrate that it took reasonable steps to ensure the purchaser was aware of the exemptions it was relying on, this could be used as a defense against the SEC’s claim of selling unregistered securities.

No Defense
Reference: (e) Offers and sales of securities pursuant to this section shall be deemed not to affect the availability of any exemption or safe harbor relating to any previous or subsequent offer or sale of such securities by the issuer or any prior or subsequent holder thereof.

Explanation: The text indicates that offers and sales of securities under this section do not impact the availability of any exemption or safe harbor for previous or subsequent transactions. Therefore, having an approved IPO does not protect the company from being sued for selling unregistered securities.

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