Coinbase Is An Unregistered Securities Exchange, Suit Says

March 16, 2022

By Charlie Innis | Law360 (March 14, 2022) -- Three cryptocurrency buyers claim Coinbase operates as an unregistered securities exchange and name 79 digital assets trading on the platform they believe should be classified as securities, according to a proposed class action in New York federal court.

In the amended complaint filed Friday, Christopher Underwood, Louis Oberlander and Henry Rodriguez say crypto tokens — digital assets often created by companies and built on top of existing blockchain networks — are "in fact" securities and accuse Coinbase Global Inc. of selling them in violation of federal and state securities laws.

The three buyers aim to represent a nationwide class of people who traded tokens on Coinbase between Oct. 8, 2019, and the present, and plan to form three more subclasses for residents in California, Florida and New Jersey. The suit names the company and its CEO, Brian Armstrong, as defendants.

The plaintiffs believe the 79 tokens, created by various entities and developers, qualify as "investment contracts" and meet the legal criteria for securities under a precedent set by the U.S. Supreme Court in SEC v. W.J. Howey Co. A bulk of the tokens have plunged or bounced up and down in value since they were first issued, and at least one of the three plaintiffs had bought and sold each of the tokens at different occasions at a loss, according to the complaint.

SEC v. W.J. Howey Co. led to what's known as the Howey test, which determines that an investment contract exists if a party is betting money on a common project with the expectation that profits may arise through the efforts of others.

The cryptocurrency buyers in Friday's suit said digital assets are like traditional securities because they represent an "investment in a project that is to be undertaken with the funds raised through the sale of the tokens."

Tokens are usually offered to the public through an initial coin offering, the buyers say, which itself is modeled after the traditional initial public offering process. Digital-asset developers will typically provide a document called a "whitepaper" to describe the tokens they are selling, but those documents don't meet the requirements for a prospectus under federal and state securities laws, the buyers say.

The crypto buyers also allege Coinbase acts as an "intermediary" in every transaction it carries out on its two platforms, through which the company charges transaction fees.

According to the complaint, unlike a platform that matches a buyer and a seller, Coinbase "stands between the buyer and seller," meaning that it is the "actual seller" of the tokens that trade each day on the platform.

"When a user wants to withdraw crypto-assets from Coinbase or another centralized exchange, she tells the exchange the address into which she would like her crypto-assets transferred. The exchange then debits the user's account and transfers a corresponding amount of crypto-asset from the exchange's reserves to that address," the buyers said. "The withdrawn assets come directly from the centralized exchange."

"Both of the Coinbase exchanges operate as centralized exchanges," the buyers added. "They differ in the services and fees involved, but both place all deposited assets into a centralized wallet and reflect transactions only through internal updates to each customer's account."

The three cryptocurrency buyers are alleging 15 counts of violations of federal and state securities and exchange laws, according to the complaint.

They are asking the court to prohibit Coinbase from trading tokens without legally registering as a national securities exchange or broker-dealer and are seeking damages for money they lost while trading within the class period and for the transaction fees the platform charged.

The suit arrives nearly a year after a slew of proposed class actions aimed at cryptocurrency companies alleging securities fraud were voluntarily dismissed in New York federal court.

The investors in those suits withdrew their cases after similar suits were dismissed by the courts earlier on. In one of the earlier cases, U.S. District Judge Denise Cote found that the named plaintiff had filed claims too late and didn't have standing to pursue claims for tokens he hadn't purchased.

Counsel for the plaintiffs and a representative of Coinbase declined to comment Monday.

The plaintiffs are represented by Jordan A. Goldstein and Mitchell Nobel of Selendy Gay Elsberg PLLC and Steven L. Bloch and Ian W. Sloss of Silver Golub & Teitell LLP.

Coinbase is represented by Jay B. Kasner, Abigail Elizabeth Davis, Alexander C. Drylewski and Lara A. Flath of Skadden Arps Slate Meagher & Flom LLP.

The case is Underwood et al. v. Coinbase Global Inc., case number 1:21-cv-08353, in the U.S. District Court for the Southern District of New York.

--Additional reporting by Elise Hansen. Editing by Janice Carter Brown.