This amicus brief for Coinbase is so wrong

This post originally appeared on ZeMing M. Gao’s website, and we republished with permission from the author. Read the full piece here.

Six securities law scholars file amicus brief in support of Coinbase (NASDAQ: COIN).

This report says the amicus brief is ‘devastating,’ meaning that it is overwhelmingly powerful.

But it is devastating in an entirely different way. The amicus brief is incredibly wrong, factually, legally, and morally.

The main argument of the amicus brief is that, according to the securities law, an ‘investment contract’ requires an expectation in the income, profits, or assets of a business, but because these crypto assets did not offer such contractual right to their purchasers, therefore they’re not securities.

What exactly are these rights, namely income, profits, or assets of a business, that are missing in the crypto?

The amicus brief points to (1) lack of dividend sharing by the token holders; and (2) lack of any liquidation right of the token holders at the company’s bankruptcy.

The above first is incredibly bogus. With that interpretation, only a small number of stocks in today’s stock market, namely only those that earn dividends, would qualify as securities.

The second part of the amicus brief argument is more interesting. According to this part of the argument, because every ‘investment contract’ identified by the law involves the contractual undertaking to grant a surviving stake in the enterprise, but tokens traded on Coinbase do not give their buyers such contractual right of the surviving stake of their issuing companies, therefore they are not securities.

This argument is both creative and perverted.

Let’s take XRP as an example. The truth is that if you ask XRP investors, the vast majority of them had believed that they were buying an interest in the future of Ripple. This ‘interest’ is the understanding or sense that the value of the XRP coin is closely associated with the success of Ripple as a company. Very few retail investors understood the fact that the XRP token did not carry any contractual guarantee of any stake in the underlying company, Ripple. In other words, they didn’t know they were second-class ‘stakeholders’ compared to the company’s equity shareholders. They were the ones that were put on the front to bear all consequences of the risks but without being promised the traditional shareholders’ rights. Rather, they were promised of the benefit of the ‘number go up.’ It was good to Ripple that these buyers did not understand all this but only understood the ‘number go up’ narrative. The tokens were sold because of that.

That is, crypto coins and tokens are offered with deception to sell a completely speculative asset under the disguise of sharing the upside of the issuing company’s future but without any explicit contractual promises.

The traditional stock issuer could not even dream of such a security to sell. But it worked for the crypto issuers.

But this amicus brief argues that tokens offered are not a security precisely because of the above deception, not in spite of it.

In other words, the argument is that a deceiver should be rewarded for a successful deception. The issuers were more clever than buyers, and therefore they deserve to be not only rewarded but also protected.

I can’t think of a more corrupt and perverted way to interpret the law.

Note that the above is not to say that XRP buyers thought they were buying a formal equity stake, i.e., stock, of the company Ripple. Some might have thought that, but that’s not the point.

In the securities law analysis, people’s understanding of the legal terms is not operative. According to the Howey test, the operative force here is the investors’ subjective association (an ‘expectation’) between the price of the token and the future of a ‘common enterprise,’ which in the case of XRP is Ripple. It is hard to argue that the above is not the case in most cryptocurrencies.

Some may argue that, by the above standard, every coin or token, including Bitcoin, would be a security per se without any analysis. Shocking, but that would be close to the truth, but with a significant principled exception:

What matters is not the existence of a link between the success of the token and any existing company, but whether the associated company is a ‘common enterprise‘ in the meaning of the Howey test. It is for this reason that control or centralization, or lack thereof, is the key. And it is for the same reason that the original bitcoin is not a security because its issuer issued the coins with a unilateral contract with zero pre-mining, and further cut himself off from the control of the system by virtue of a locked protocol.

However, if others later inserted themselves into the control by changing the protocol and thus converting Bitcoin into a security, that is a different matter. What came from that is no longer bitcoin but an entirely different thing based on a new contract. See Even BTC has become a security.

But there are additional reasons why this amicus brief is totally wrong:

(1) The reality

The vast majority of the stocks today are traded based on speculative valuations, not for earning dividends or otherwise sharing an income of the company. Some valuations are at least based on certain fundamentals which have their origin in income and dividends, but many simply don’t have any fundamentals at all but only speculations upon speculations. For the buyers of these stocks, there is no contractual guarantee of the profits of the issuer.

Yet all these stocks are securities and no less securities than others. There isn’t even a question ever raised about this. They are securities not because they were born with a label ‘a security’ on their forehead but because there exists an identifiable investment contract in offering these financial instruments to buyers, and the investment contract offered meets the Howey test.

Now, going back to certain rigid words in 1930s to argue that these actually do not qualify as securities would be a very strange argument. It would be simply out of touch with the reality. Yet that is exactly what this amicus brief effectively does for crypto.

(2) The spirit and the purpose of the law

Going beyond the letters of the law, let us just think about the spirit or the purpose of the law.

The purpose of securities law is to protect investors by maintaining the trust in the financial markets.

For that, it is clear that the more speculative an asset is, the more likely it would become a suspect of being a security. This is because, being more speculative, there is more room for committing fraud and more chance to victimize investors. And at the same time, the same investors are likely to be more vulnerable due to the temptations of high-level speculations.

How could anyone then argue that an asset is not a security simply because it is too speculative?

Of course, the amicus brief does not say that straightforwardly but rather argues that cryptocurrencies broadly are not a security simply because they are not based on an explicitly identifiable contract that guarantees an interest in an income and liquidation right to buyers. But these are logically equivalent.

Therefore, not only is the position of the Coinbase amicus brief wrong to the letters of the law, but it also runs afoul of the purpose and the spirit of the law.

Usually, when these academics talk about blockchain and crypto, they know the law but don’t know the technology. Therefore, when they are wrong, they make understandable mistakes. But this amicus brief is simply wrong on the law itself before you even get to show its ignorance of the technology.

Skillful lawyers can always argue for any side in which they take an interest. This one is a great example. I just hope that the Securities and Exchange Commission (SEC) and the court are not fooled.

May the court be warned that the authors of this amicus brief are not the friends (amicus) of the court but that of the crooks.

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