Coinbase’s path to legal victory against the SEC looks murky after latest setback

Last week's hearing for Sam Bankman-Fried, where a judge sentenced the disgraced FTX founder to 25 years in prison, may have dominated headlines, but a lesser-heralded decision against Coinbase will likely prove more consequential for the crypto industry.

On Wednesday, Judge Katherine Failla of the Southern District of New York rejected Coinbase's motion to dismiss the SEC's lawsuit against the leading U.S. crypto exchange, forcing the proceedings to move to the next phase of the trial: discovery, where the two parties seek and exchange information, such as internal documents and witness depositions.

On its surface, Failla's decision was expected—a judge tossing out a lawsuit brought by the federal agency in such a preliminary stage had a slim likelihood, though she did agree with Coinbase that its self-custody wallet doesn't make it a broker. Still, after the initial hearing in January where Coinbase made its case to dismiss the entire lawsuit, Failla seemed skeptical and overly critical of the SEC's arguments that the crypto exchange was offering unregistered securities, creating a false sense of optimism within the industry that Gary Gensler would face an embarrassing loss in his aggressive campaign against the Wild West sector.

Wednesday's decision dashed those hopes, as Failla systematically dismissed each facet of Coinbase's argument, from its invocation of the Major Questions Doctrine to its assertion that investment contracts need to include a formal contract. She even rejected Coinbase's comparison of crypto assets to Beanie Babies, siding with the SEC that collectibles can be "independently consumed or used," while many cryptocurrencies gain value from their digital network.

I spoke with Todd Phillips, a banking and administrative law professor at Georgia State University, to understand the implications of Failla's decision. Phillips had written a "friend-of-the-court" brief arguing that the crypto industry should not qualify under the Major Questions Doctrine, a Supreme Court principle that says Congress cannot delegate to agencies like the SEC on matters of major political or economic significance, and Failla agreed.

He told me that the motion to dismiss phase of the case allows both sides to make their arguments on legal grounds, while discovery and the trial itself are where the two sides argue the merits of the facts. In other words, Failla's decision last week meant that she agreed with the SEC's interpretation of legal precedent that the crypto assets offered on Coinbase appear to be securities, and therefore Coinbase is operating as an unregistered exchange and broker. During the trial, Coinbase will have to argue the facts around the cryptocurrencies, such as whether issuers like Solana were indeed promoting the assets.

The difficulty for Coinbase will be that there are not many facts to dispute. In its original complaint, the SEC honed in on 13 crypto assets, laying out its reasoning for why investors might expect profits based on the efforts of the issuers. The argument is no longer whether investment contracts need formal contracts, or whether secondary transactions can qualify as investment contracts, as Coinbase hoped to achieve with its motion—it's whether any of the assets fit under the SEC's now-established definition of what constitutes an investment contract.

As Phillips explained, Coinbase could pull a page from the Ripple playbook and seek internal documents from the SEC that highlight internal division within the agency about how to supervise the crypto industry, or even around its approval of Coinbase's IPO. Even so, Failla rejected Coinbase's "fair notice" argument that the agency had not provided proper warning that the crypto assets traded on digital platforms could constitute securities, ruling that there was sufficient public instruction through written guidance and litigation.

So what could come next? Coinbase has a few options. If the case proceeds under the current conditions, Failla would likely issue a summary judgment, meaning she would find no material disputes on the facts. In that eventuality, the SEC seems poised to win.

Coinbase has two more favorable scenarios. In the first, the exchange drags out the discovery process, which could easily last over a year, hoping that a Republican wins the presidential race and forces Gensler out of the SEC, with the new administration potentially dropping the case. In the second, Coinbase immediately appeals the decision, forgoing the next phase of the trial and going straight to the Second Circuit, and eventually to the Supreme Court. As Phillips told me, Failla made her decision based on decades of Supreme Court rulings, and an appeals court is likely to agree. "The only court that can overturn Supreme Court precedent is the Supreme Court," he said.

Leo Schwartz
leo.schwartz@fortune.com
@leomschwartz

This story was originally featured on Fortune.com