Coinbase's SEC Clash Faces First Major Test as Judge Weighs Longshot Dismissal

• Coinbase is poised to argue with the Securities and Exchange Commission over whether its business model is violating U.S. law.
• A federal judge in New York will hear a lengthy four hours of oral arguments in the case, and the crypto industry will see whether her eventual decision about throwing out the SEC's case will help or hurt its momentum against the regulator.

Coinbase is about to make its case in a federal courtroom that the U.S. Securities and Exchange Commission (SEC) is wrong about its legal arguments that the crypto exchange has been trading unregistered securities. What the New York judge does next could have serious consequences for the wider industry's clashes with the regulator.

The company has asked Judge Katherine Polk Failla of the U.S. District Court for the Southern District of New York to throw out the case – a longshot request, but one that she may be taking very seriously. She's booked four hours of back-and-forth with Coinbase and the SEC on Wednesday – an unusual depth of oral arguments for such a motion, which often tends to favor the government side in this kind of enforcement case.

"When the government is suing people they usually don't lose on summary judgment motions," said Patrick McCarty, a financial consultant and former SEC lawyer who teaches crypto classes at Georgetown Law. "But it's possible – very possible."

Judge Failla could give significant momentum to either side when she rules on the motion – probably not this week, but within the next couple of months. She'll either land in the camp of fellow SDNY Judge Analisa Torres, who ruled – also in summary judgment – that the SEC strayed in some of its claims about XRP being a security in the case against Ripple, or Judge Jed Rakoff, who just gave the SEC a win in its action against Terraform Labs.

Read More: Coinbase Poised to Make Final Pitch in Bid to Kill SEC Accusations Quickly

The SEC interprets the key law on identifying securities – known as the Howey test – as saying that a digital asset purchaser who has been guided to expect profit from that purchase is likely buying a crypto security. But Coinbase contends that the tokens being traded on its popular platform aren't securities if there's no formal obligation that says the issuer owes the purchaser a share of profits or income.

The case could be thought of as the first major action that "brings into focus this debate about whether – in fact – these things are investments contracts or securities transactions under the Howey test," McCarty said.

He said this current motion puts Failla in an interesting position, "kind of caught between Judge Torres and Judge Rakoff," both judges in the same court that handles so much of the SEC's caseload.

Each side will have two hours to make its case directly to Failla, which McCarty noted was an especially long time. If the judge isn't convinced that Coinbase has justified an early resolution in the company's favor, the dispute will proceed toward trial, in which case the company could pursue SEC internal documents revealing conversations among officials as they decided whether to go after the exchange.

The agency and the company aren't generally arguing over the facts of what's happening, but on how existing law should treat it. Deciding where Howey fits in is "going to contribute to the continuing development of legal precedent," said Chris Odinet, a professor at the University of Iowa College of Law whose research has a focus on digital assets.

"The stakes are extremely high, because they're so inherently tied to the business model," Odinet said. However, he doesn't necessarily interpret the lengthy four hours of scheduled discussion as a sign pointing in either direction, because he said the issues are highly technical and may require that much questioning.

But whatever happens on this motion, the dispute over crypto transactions in the secondary market will almost certainly be elevated to the appeals courts.

"It's not like this is going to end the debate," McCarthy said. "It's just going to be another chapter."

Coinbase's arguments this week also come on the heels of the SEC's capitulation in the spot bitcoin exchange-traded fund (ETF) approvals, which agency Chair Gary Gensler granted came out of the SEC's court loss against Grayscale. While that was a different legal question, the regulator was declared by a federal court to be taking "arbitrary and capricious" actions against a crypto firm, and Coinbase is prepared to make a similar claim here.

The judge has previously differed with SEC leaders in at least one significant crypto point: She said last year that ether (ETH) is a commodity, not a security. While SEC officials once suggested that may be the case, they've more recently narrowed their position to bitcoin (BTC) being the only token that's definitely outside SEC jurisdiction.