If you are reading this, the chances are good that you have heard of cryptocurrency.  But what is cryptocurrency?  How does it work?  Is it actually currency?  Is it property? Who regulates it?  All great questions and all with answers that leave a little to be desired.  Investopedia.com explains that “[a] cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers.”  Essentially, cryptocurrency is an attempt to replace government-backed currency through a digital medium using cryptography to try to replicate the security that government backing provides traditional currency.  Many people feel that cryptocurrency provides better security and privacy protections than traditional currencies.

But is it actually currency?  Well, yes and no. Currency is only currency if it can be used as a generally accepted medium to engage in trade.  In order to do that, the currency has to be acceptable to members of the public as a means to pay for goods and services.  While some companies will accept payment in various cryptocurrencies, most companies and individuals still seek to be paid in traditional government-backed currencies.  But that is changing.  On September 7, El Salvador became the first country in the world to accept Bitcoin as legal tender.  Still, relatively few consumers appear willing to accept cryptocurrency as an alternative to government-backed currencies.  Instead, most who trade in cryptocurrencies do so because they see it as a promising investment opportunity.

If people see cryptocurrencies as an investment rather than an actual currency, what are they really?  The IRS classifies cryptocurrency as property for tax purposes.  The Commodity Futures Trading Commission (CFTC) considers cryptocurrencies to be commodities.  The SEC has said that some cryptocurrencies may be securities.  So, who regulates cryptocurrencies?  Currently, there is very little regulation in the crypto space.  Both the CFTC and SEC have signaled their willingness to regulate cryptocurrencies, but the industry remains highly unregulated.  While it appears that CFTC has a stronger basis for regulating cryptocurrencies, the SEC has already begun bringing actions against actors in the industry.  On September 1, the SEC announced that it had brought an action for fraud against BitConnect, an online crypto lending platform, and its founder accusing the company of orchestrating a massive Ponzi scheme.  The SEC routinely brings enforcement actions in cases involving massive fraud, and Ponzi schemes in particular.  But the SEC’s case against Coinbase represents new ground for the Commission.

On September 7, Coinbase, a cryptocurrency exchange platform, announced that it had received a Wells notice from the SEC indicating that the SEC planned to sue Coinbase over its upcoming “Lend” program.  Coinbase’s Lend program is based on USD Coin (USDC), “a type of cryptocurrency known as a stablecoin. USDC is redeemable on a 1:1 basis for US dollars, backed by dollar denominated assets held in segregated accounts with US regulated financial institutions.”  As part of the Lend program, Coinbase “lend[s] your USD Coin to verified borrowers, allowing you to earn 4% APY – over 8x the national average for high-yield savings accounts.”  Sounds simple enough.  That sounds like something banks do all the time.  However, Coinbase is not a bank and is not regulated as such.  Coinbase is not FDIC insured.  Most of the safeguards protecting consumers in transactions with banks do not apply to Coinbase or other companies operating in the crypto sphere.  That being the case, the SEC appears to be stepping in to provide protection to consumers.

But how can the SEC regulate this product?  Most cryptocurrencies do not fall within the definition of a security; however, the product offered by Coinbase is not actually cryptocurrency.  Instead, consumers are lending cryptocurrency to other consumers or entities in order to gain a 4% return on their assets.  Taken in that context, the Lend program may be considered a “note” or even a “bond” by the SEC, both of which are heavily regulated by SEC and require significant disclosures to investors.  That appears to be the route the SEC is taking.  However, there are issues with this theory.  As BlackRock explains, “Bonds – also known as fixed income instruments – are used by governments or companies to raise money by borrowing from investors. Bonds are typically issued to raise funds for specific projects. In return, the bond issuer promises to pay back the investment, with interest, over a certain period of time.”  Similarly, the definition of “security” included in the Securities Exchange Act of 1934 excludes “any note . . . which has a maturity at the time of issuance of not exceeding nine months.” 

Coinbase’s website states that “You can opt-out at any time,” and “You can continue to send and sell your crypto without delay and with no fees.”  The description of the Lend program does not appear to contemplate repayment over a specified period of time like a traditional bond.  Additionally, the ability to opt out and trade a consumer’s cryptocurrency may bring the program within the nine-month exception in the 1934 Act.  But why would the SEC bring an action against Coinbase if the basis for the action is debatable.  Two reasons: 1) SEC wants to see if the courts will allow it to bring such actions given the lack of regulation in the crypto sphere, and 2) SEC wants to push Congress to enact legislation allowing it to regulate and bring enforcement actions against crypto companies.  A clear mandate from Congress would be welcome, but the SEC is comfortable bringing enforcement actions without a clear mandate if the courts allow it – insider trading enforcement comes to mind.  Either way, the case against Coinbase will be a bellwether for future SEC enforcement and regulation in the cryptocurrency industry.

The attorneys at Chilivis Grubman represent clients of all types and sizes in connection with SEC investigations and related securities litigation.  If you need assistance with such a matter, please contact us today.