Coinbase Wells Notice: SEC prepping enforcement action for securities violations

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Coinbase (NASDAQ: COIN) says it has been warned by the U.S. Securities and Exchange Commission (SEC) to expect imminent legal action for violating federal securities laws.

On Wednesday, Coinbase disclosed that it had received a Wells notice from SEC staff regarding a “preliminary determination” that the regulator should “file an enforcement action” against the digital asset exchange. The SEC believes it has identified securities violations relating to “aspects of the Company’s spot market, staking service Coinbase Earn, Coinbase Prime and Coinbase Wallet” products.

The SEC’s action has been expected for some time, particularly after civil and criminal charges were filed last July against a former Coinbase staffer caught trading on advance knowledge of which new tokens would be listed on the exchange. The SEC said at the time that “at least nine” of the tokens involved in the insider trading scandal were unregistered securities but CoinGeek believes there are other tokens being traded on the crypto platform that fall into the same category including BTC and Ethereum.

Coinbase CEO Brian Armstrong responded to the news by tweeting that the SEC “simply has not been fair, reasonable, or even demonstrated a seriousness of purpose when it comes to its engagement on digital assets.”

Coinbase’s chief legal officer Paul Grewal followed with a typically defiant blog post—the sheer length of which suggests Wednesday’s news was long anticipated—slamming the SEC for apparently making up its mind after conducting a “cursory investigation.”

Grewal claimed that Coinbase would welcome a legal fight “to provide the clarity we have been advocating for and to demonstrate that the SEC simply has not been fair or reasonable when it comes to its engagement on digital assets.”

But Grewal complained that the Wells notice “does not provide a lot of information for us to respond to,” including which assets the SEC believes are securities (Hint: all of them, including BTC.) Grewal also complained that the SEC should have acted before Coinbase’s 2021 direct listing on the Nasdaq and that the SEC’s offers for ‘crypto’ companies to register with the regulator aren’t serious.

As he has done in the past, Grewal insisted that Coinbase “does not list securities” due to its “rigorous process to analyze and review each digital asset before making it available on our exchange.” And yet it wasn’t so long ago that Coinbase sought to “accelerate the process by which we review assets and add them to the site” because its stock price was tanking, and it needed to boost its commission revenue from function-free altcoin trading.

But somehow, Coinbase never found the time to list Bitcoin SV (BSV), despite its focus on utility and its unbounded scaling capacity. Even stranger, it was only last month that Armstrong pleaded with developers to “get the blockchains to be more scalable.” Just last week, BSV reported over 50 million transactions in a 24-hour period. And still, no BSV on Coinbase. Why is that? Oh, right…

Friend of the court, not of the convict

In related news, Coinbase filed an amicus brief last week with the U.S. District Court for the Western District of Washington in support of its former staffer, Ishan Wahi, who—along with his brother and a third conspirator—is trying to dismiss the SEC insider trading lawsuit. In February, Wahi pleaded guilty to conspiring to commit wire fraud in the associated criminal case in New York.

Coinbase’s brief is based on its view that “the SEC’s suit hinges on the assumption that Coinbase … has unlawfully listed at least a small number of securities on its platform.” The filing doesn’t really cover any new ground, primarily serving to rehash Coinbase’s criticisms of the SEC’s alleged proclivity to “regulate through enforcement actions” while urging the court to “dismiss this lawsuit as foreclosed by the long-settled understanding of the securities laws.”

Unconscionable litigation gimmicks

Coinbase’s legal reps appeared before the U.S. Supreme Court on Tuesday, trying to convince the justices that arbitration clauses in the exchange’s terms of service prohibit customers from taking the exchange to court.

Basically, Coinbase is trying to duck two lawsuits by forcing the parties to negotiate behind closed doors, hopefully leaving no trail of legal breadcrumbs that other aggrieved customers might be encouraged to follow.

Coinbase v. Bielski involves a customer who wants Coinbase to reimburse him for the $31,000 he lost to a scammer due to the exchange’s allegedly lax security. Suski v. Coinbase is a class action brought by customers who claim the exchange misrepresented the rules of a Dogecoin Sweepstakes that didn’t actually require them to buy or trade $100 worth of Dogecoin.

Neither suit is particularly concerned with digital assets, instead focusing on the corporate world’s increasing use of arbitration clauses to restrict customers’ ability to pursue redress through the courts. As such, the Supreme Courts’ ruling could spell trouble for many U.S. companies, as well as for individuals like former President Donald Trump, who inserts arbitration clauses into his employees’ labor contracts.

Lower courts have sided with the plaintiffs, including a California federal court that called Coinbase “unconscionable” for employing a “litigation gimmick” to bully its users into doing things its way. Last July, a federal appeals court refused to stay the lawsuits while Coinbase’s appeal of the California ruling is pending, prompting Coinbase to petition the Supreme Court for a stay. There’s no timeline for when the justices might render their verdict.

Circle the USDC wagons

Meanwhile, reports have surfaced that Coinbase offered its USDC partner Circle an emergency line of credit to support the flailing stablecoin after billions of its reserve assets were frozen.

This week, Fortune quoted a source who claimed knowledge of how Circle reacted after USDC lost its 1:1 peg with the U.S. dollar. USDC briefly plunged below 88¢ after Silicon Valley Bank (SVB) abruptly collapsed on Friday, March 10, and stranded $3.3b of the cash reserves backing the stablecoin. USDC only regained its peg after the Federal Deposit Insurance Corporation (FDIC) stepped in that Sunday to guarantee all SVB deposits.

Fortune reported that, before the FDIC’s intervention, Coinbase offered Circle a credit facility that would have ‘guaranteed full liquidity for USDC reserves,’ thereby ensuring USDC redemptions could continue on March 13 morning. It wasn’t until Wednesday that Circle reported having “cleared substantially all of the backlog of minting and redemption requests.”

The backlog may be clear, but USDC customers continue to express unease over the stablecoin’s health. When SVB failed, USDC had a market cap of nearly $44 billion. As of this week, it’s struggling to stay above $35 billion. USDC is a partnership of the Centre consortium, which consists of Coinbase and Circle.

That Coinbase would rush to its partner’s defense isn’t surprising, even less surprising, given that Coinbase’s fiscal health is increasingly reliant on the interest generated from safely storing around $2 billion in USDC on behalf of its customers.

USDC’s shrinking market cap will cut into Coinbase’s interest revenue, which may explain why Coinbase halted USDC redemptions during Circle’s wild weekend. Coinbase cited “heightened activity” to justify denying customers access to their USDC.

Coinbase’s eagerness to ride to Circle’s rescue prompted some critics to question exactly where the exchange would find the necessary billions. With the exchange losing over $2.6 billion last year and corporate cash on hand at the end of 2022 shrinking to only around $1 billion more than the hole in Circle’s reserves, these critics may be right to seek more information.

Recall that the prime factor in the downfall of the FTX exchange was its willingness to funnel customer cash to its Alameda Research partner to cover the holes in Alameda’s balance sheet. Nobody’s accusing Coinbase of using customer funds to backstop USDC, but greater transparency regarding exchanges’ financial dealings would do wonders in these uncertain times.

Adding insult to injury, the Twitter account of Circle’s chief strategy officer Dante Disparte was hacked on Wednesday. The account quickly began issuing scam offers of loyalty rewards to USDC users to atone for this month’s disruptions. Circle was forced to inform users of the hack and warn them not to click any links issued by the now-suspended account.

Unbank shot

Coinbase’s problems aren’t limited to USDC. The near-simultaneous failures of New York’s crypto-friendly Signature Bank and California’s Silvergate Bank (NASDAQ: SI) robbed exchanges and market-makers of the two main 24/7 USD-crypto settlement networks.

Last weekend, New York Community Bancorp subsidiary Flagstar Bank acquired Signature’s assets, with the notable exception of any digital asset banking or crypto-related assets or deposits. Signature’s crypto settlement platform Signet— developed by Tassat Group—lives on, although for how much longer is anyone’s guess.

On Monday, the Wall Street Journal reported that Coinbase had informed clients that it would no longer support Signet transactions. Coinbase is said to be looking for an alternate settlement mechanism until Signet’s long-term fate becomes clearer. In the meantime, USD transactions will only occur during normal banking hours.

On Tuesday, CNBC reported that many digital currency firms are eyeing new banking relationships in Switzerland. One anonymous local bank advisor said they’d been “inundated with requests” for banking services. Dominic Castley, chief marketing officer at digital currency-friendly Swiss bank Sygnum, said his group had seen “a significant increase in onboarding enquiries.”

Time to update that passport

It’s not all bad news for Coinbase. The company announced Tuesday that its Brazilian customers could now top up their accounts with the local Real currency following the exchange’s integration with the instant payment platform Pix. Previously, Brazilian customers’ crypto purchases were only possible with credit cards. Coinbase’s Brazilian app is also now fully available in Portuguese.

The Brazilian updates are part of Coinbase’s frantic pivot away from the U.S. market, which the exchange’s brain trust increasingly views as hostile territory. Last week, Bloomberg reported that Coinbase has begun talking to international market-makers and institutional investors about setting up an entirely separate platform based outside America.

Coinbase previously announced a ‘Go Broad, Go Deep’ strategy to expand the exchange’s footprint on every continent save Antarctica. (Suck it, penguins!) The financially struggling Coinbase is apparently eager to horn in on the lucrative—albeit legally sketchy—crypto derivatives market currently dominated by the altogether sketchy Binance exchange.

Coinbase hasn’t entirely given up on the U.S. market, as evidenced by its ongoing efforts to convince regulators to cut the exchange some slack. On Friday, March 24, a trio of Coinbase execs led by CEO Armstrong will participate in Crypto435 Live, a Twitter Space devoted to the company’s push for “pro-crypto policies at the state and federal level.”

Coinbase launched Crypto435 earlier this month to encourage its customers to contact/harass local politicians and promote “pro-innovation policies.” Coinbase execs would do it themselves, but they’ve burned too many bridges with tone-deaf op-eds questioning regulators’ understanding of the law.

Shooting the messenger

In January, Coinbase proudly declared that its Coinbase Wallet was “making web3 exploration safer and more secure for everyone through a new suite of industry-leading safety features.”

However, a new report by the developers behind the ZenGo wallet found vulnerabilities in leading Web3 Transaction Simulations that could allow hackers to trick simulation engines. Coinbase Wallet was found to be particularly vulnerable to these types of transaction subterfuge.

ZenGo stated that it had “responsibly disclosed these vulnerabilities to the respective vendors and these issues are now fixed.” For their efforts, ZenGo was awarded a grant from the Ethereum Foundation and “multiple bug bounties” from the vendors, including Coinbase.

However, when Coinbase learned that ZenGo was planning to release its findings, a representative asked ZenGo to “remove all references to Coinbase, the report, and the transaction preview details from your public statements and conference presentation.” The rep added that the HackerOne cybersecurity outfit’s code of conduct “explicitly prohibits public disclosure of report information without our authorization.”

ZenGo CTO Tal Be’ery responded to this attempted brushback by tweeting, “This is NOT the way to treat security researchers.” Be’ery added that “A bug bounty is not a gag order. We will not be bullied or intimidated. #CoinbaseWallet you can have your money back.”

Impeccable timing

Speaking of getting one’s money back, Coinbase shares shot up nearly 12% on Tuesday, closing just under $84, a 2023 high-water mark. Cathie Wood’s ARK Invest funds, which went on a Coinbase buying spree as the share value plunged, dumped nearly 161,000 shares on Tuesday to help offset some of those losses.

Good thing, as Coinbase shares fell back to earth on Wednesday, closing down more than 8% on news that the Federal Reserve had bumped interest rates up another quarter-point. The shares fell another 16% in after-hours trading as news of the Wells notice broke.

This begs the question of what CEO Armstrong knew regarding that Wells notice and when he knew it. Armstrong has sold $5.9 million worth of his Coinbase shares this month, including $2.2 million on Tuesday—for those of you keeping track, that brings his 2023 year-to-date total sales to around $18 million.

Grewal sold around $179,000 of his shares on Wednesday, taking his YTD total to over $457,000. All told, Coinbase insiders have dumped $26 million of their shares this year, while insider share purchases are barely one-tenth of that total. Honestly, it would be much easier to buy into Coinbase senior management’s constant ‘our future’s so bright we gotta wear shades’ pose if they publicly demonstrated the least bit of faith in their long-term prospects.

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Ethereum, FTX and Tether—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.