Coinbase Global Is In Serious Trouble

Summary The SEC has filed a lawsuit against Coinbase Global, alleging that the company operates as an unregistered broker-dealer and engages others in unlawful activities. The lawsuit claims that Coinbase has knowingly allowed the trading of cryptocurrencies that could be classified as securities, despite having internal measures to identify such assets. This development, along with other legal issues and a decline in trading volume and user activity, makes the outlook for Coinbase Global and its investors increasingly bleak. 2023 is proving to be a really dark and painful time for Coinbase Global ( COIN ) and its shareholders. The most recent development that came out that will likely have a deleterious effect on the company was revealed on June 6th. In short, the SEC (Securities and Exchange Commission) decided to file a lawsuit against the company, claiming, amongst other things, that the firm is operating as an unregistered broker-dealer and that it is engaged in a variety of unlawful activities. In response to this development, shares of the company closed down 12.1% for the day, but not before initially falling as much as 21%. In my mind, this further solidifies why investors and market participants should be bearish about the company. In addition to operating in a space that I believe has little to no true long-term value, the company now has to deal with a legal crisis that could prove very costly in the long run. An awful but unsurprising development On June 6th, shares of Coinbase Global plunged, dropping in response to a lawsuit filed by the SEC. In the lawsuit, the SEC alleges a number of issues regarding the company. As I mentioned already, one allegation is that the company is essentially operating as an unregistered broker-dealer. In addition to this, they claim that Coinbase Global commingled funds, unlawfully operated as an exchange, and even provided clearing house functions that it should not have given its registration status or lack thereof. This is not the only legal issue that the company is facing right now. Multiple states are also putting pressure on it and other firms. Alabama, for instance, recently gave Coinbase Global 28 days to justify why it shouldn't be forced to stop selling unregistered securities in that state. Alabama is one of just ten different state securities regulators that are part of a joint enforcement action against the company. However, this article will focus not on the state issues, but instead on the federal. The entire lawsuit itself is just over 100 pages. So the purpose of this article will be to zero in on some of the key facets that investors should be aware of. In the very opening of the lawsuit, the SEC summarizes the core issues rather eloquently. They start by saying that, "the Coinbase Platform merges three functions that are typically separated in traditional securities markets-those of brokers, exchanges, and clearing agencies. Yet, Coinbase has never registered with the SEC as a broker, national securities exchange, or clearing agency, thus evading the disclosure regime that Congress has established for our securities markets. All the while, Coinbase has earned billions of dollars in revenues by, among other things, collecting transaction fees from investors whom Coinbase has deprived of the disclosures and protections that registration entails and thus exposed to significant risk." I am no lawyer. But I do have extensive experience in the securities industry. In addition to the analysis that I perform on a daily basis, I ran a state-registered investment advisory firm for nine years. And I am in the process of setting up another. I have explored a great deal when it comes to setting up a broker-dealer as well, given that some of my future endeavors might involve such a legal structure. At the core of the argument, as I see it at least, is that Coinbase Global would not have any of these as regulatory problems if the cryptocurrencies that they have on their platform cannot be classified as securities. Author In my mind, a security is ultimately backed by some asset, or it is backed by something that is backed by an asset. But that is not the framework in which the SEC operates. Thanks to a Supreme Court ruling, there is a very specific test that's utilized called the Howey Test. This can be seen in the image above. At the end of the day, all four of these must be answered with a yes in order for an asset to be classified as a security. Given the nature of cryptocurrency, there has been a tremendous amount of debate over what is an asset and what is not. Regulators, such as SEC Chairman Gary Gensler, have long claimed , for instance, that Bitcoin is not a security according to the Howey Test. This is because Bitcoin does not involve funds flowing into a common enterprise, there is no promoter or issuer of it, and because an investor's success ends up not being reliant on the efforts of other parties. But now there are 10s of thousands of cryptocurrencies out there. And each one has some degree of differentiation. In its enforcement action that it filed against Binance the other day, the SEC listed 61 different cryptocurrencies that it considers to be securities. Meanwhile, in the lawsuit against Coinbase Global, the Commission listed 13 different cryptocurrencies that Coinbase Global facilitates trading for that it considers to be securities. To be very clear, they did say that list is non-exhaustive. I won't go through the entire list, but I will give a couple of examples. The first that I have decided to mention is SOL, or Solana. For those not familiar, SOL is the native token of the Solana blockchain. Between May of 2018 and early March of 2020, the creator of SOL, Solana Labs, filed multiple forms with the SEC in which it claimed that offers it was making to investors that involved the issuance of SAFTs (Simple Agreement for Future Tokens) In exchange for capital to build out its business, involved the sale of securities. Specifically, the securities in question would be the SOL that the SAFTs we're supposed to convert into. The company ended up going on to raise hundreds of millions of dollars, including $314 million in August of 2021. While SOL was very open in that it viewed its offerings as offerings of securities, this was not the case with every example provided by the SEC. An example on the opposite end of the spectrum was DASH, which is the native token of the Dash blockchain. In short, the Dash platform operates as a financial transactions service for its customers. Earlier this year even, the SEC asserted that DASH was a security, an allegation that the official DASH community took significant issue with and addressed on Twitter. At the core of the SEC's argument is that its Masternodes (a subset of users who 'purportedly' run the network and that provide extra services through it) not only exert significant control over the platform, but also that they have made statements that would lead outsiders and investors to view DASH as an investment that they should expect to profit from. One such statement involved the fact that the platform's mission is "to provide greater financial freedom by delivering and improving financial solutions which are secure, reliable, decentralized, and usable for all." If it were just a case of Coinbase Global accidentally allowing some securities onto its platform in an environment that nobody will say is crystal clear, this would probably be a rather small matter. But the problems are bigger than that. Back in late 2016, according to the SEC, Coinbase Global released a document on its website called, 'A Securities Law Framework for Blockchain Tokens' That talked about the Howey Test and that even acknowledged that some cryptocurrencies or tokens might very well pass it. The company followed this up in late 2018 with its publication of its 'Coinbase Crypto Asset Framework'. This framework included with it a listing application form so that crypto asset issuers and promoters who are hoping to make their cryptocurrencies available on the company's platform could apply. Many of the questions asked in the application could be used, according to the SEC, to perform a Howey analysis. From this, the company eventually went on in 2019 to create its own Crypto Rating Council, which created its own test to measure the likelihood that any particular cryptocurrency would pass the Howey Test. On its own, this is perfectly fine. However, the company found itself under pressure to grow more rapidly and, along the way, it ended up onboarding onto its platform even cryptocurrencies that ranked as high risk according to this new framework. In one case, a team at the company even allegedly advised a cryptocurrency issuer about statements that had been made regarding a cryptocurrency that could elevate its risk. And they even went so far as to advise that issuer to change certain language that they use when describing the asset and to avoid making problematic statements moving forward. What this all shows to me is not only did Coinbase Global understand the law, they purposely avoided compliance with it and blatantly disregarded their own internal measures that were telling them that certain cryptocurrencies were almost certainly classifiable as securities. There are other issues as well. For starters, Coinbase Global has gone so far as to create what it calls its Coinbase Staking Program and to market it as an investment opportunity. On its website, for instance, the company even claimed at one point that users who would like to stake their cryptocurrency can 'earn on as much' as they want. Examples of annual yields as high as 7.5%, plus bonuses from time to time, have proven to be useful marketing initiatives. Staking on its own may not be all that problematic from a regulatory perspective. But it is a problem when the cryptocurrencies being staked are classified as securities. And according to the SEC, the five stakeable assets that Coinbase Global provided users an opportunity with passed the Howey test in large part because the Coinbase Staking Program was classifiable as an investment contract. Furthermore, this is an issue because the individual cryptocurrencies or tokens included in the Coinbase Staking Program are segregated, pooled, and staked by asset class. But each individual cryptocurrency is not further segregated by account holder. So for instance, all SOL units that are staked are held in the same account. This is only one example of a commingling of assets. According to the SEC, commingling occurs across the Coinbase Platform, as well as through both its Prime and Wallet features. For those not familiar, Coinbase Prime is described by management as a 'prime broker for digital assets', while the Coinbase Wallet serves as an individual wallet that routes orders through third party crypto asset trading platforms in order to access liquidity outside of the company's platform. To me, this is especially problematic when we talk about Coinbase Prime. Based on the data provided, Coinbase Prime serves as a full-service prime brokerage platform that provides customers with institutional grade trading activities and other features. But to use the word 'brokerage' without actually being one seems to me to not just tiptoe on the line of fraud, but to pass over it. Pain just keeps piling on Truth be told, I have no idea how this legal debacle will play out. The allegations being made by the SEC are damning and some of the quotes and other pieces of evidence that they provide look incredibly incriminating. But the picture most certainly looks awful in the grand scheme of things. In order to rectify this situation, one avenue that Coinbase Global could explore is to remove any questionable assets from its platform. Coinbase Global There is still uncertainty as to whether Ethereum should ultimately be classified as a security or not. It currently accounts for 25.6% of the $124.4 billion worth of crypto assets on the company's platform. Bitcoin is even larger, accounting for 44.7%. The miscellaneous crypto assets that consist of all of the identified problem tokens, not to mention countless others that might not be classified as securities, only account for 28.9% of these assets. Author - SEC EDGAR Data Unfortunately, such a maneuver couldn't come at a worse time. Even though customer crypto assets on the company's platform are up 65% year over year, a lot of the other metrics provided by management look painful. Revenue in the first quarter of 2023, for instance, came in at $772.5 million. That's down substantially from the $1.17 billion reported one year earlier. This decline has been driven by a couple of factors. For starters, the trading volume on the company's platform has been plummeting. In the first quarter of 2022, it came out to $309 billion. In the first quarter of this year, the number was less than half that at $145 billion. The MTUs (monthly transacting users) are also down, having fallen from 9.2 million last year to 8.4 million today. By definition, this all indicates that not only are there fewer users, but also that the users who have remained have cut down significantly on their trading activities. Author - SEC EDGAR Data To be fair, management has done well to reduce costs substantially. Even with $144.5 million of restructuring costs on the company's income statement for the first quarter of this year, its net loss of $78.9 million was far better than the $429.7 million net loss the company experienced one year earlier. Operating cash flow went from negative $91.4 million to positive $463.1 million, while the adjusted figure for this that ignores changes in working capital improved from negative $17.1 million to positive $147.8 million. And finally, EBITDA for the company expanded from only $20 million to $284 million. While these bottom line results are great to see, I believe that the long-term outlook for the company is anything but great. As I have written about before, Bitcoin on its own is very nearly worthless. Once the market does eventually come to terms with this, the company will face pain the likes of which regulators are unlikely to be able to inflict upon it. I won't make a blanket statement about cryptocurrencies in general. I believe some of them likely do have some true value to them. But with such a large portion of customer assets in the form of Bitcoin, and with the prospect of the company likely having to unload at least some of the 253 other crypto assets that it had as of the end of the most recent quarter, it's unclear exactly what the fallout will be. Takeaway At this moment, the picture for Coinbase Global and its investors looks awful. Since I wrote a bearish article on the company a little over a year ago, shares have dropped another 3.9% while the S&P 500 has increased by 8.9%. Honestly, I'm surprised that the drop hasn't been worse. This latest development spells significant costs for the company moving forward. And I'm not just talking regulatory fees. Legal costs will be a problem, further lawsuits will likely bubble up, and the company is already dealing with some issues outside of this as I mentioned previously. All combined, I have no problem downgrading the company further from the 'sell' that I had it at previously to a 'strong sell' to reflect my view that the stock should significantly underperform the broader market from here on out.