Third Circuit Coinbase Decision Pressures SEC on Crypto Rulemaking

We wanted to share an important update regarding a recent decision by the U.S. Court of Appeals for the Third Circuit that impacts the SEC’s regulation of digital assets.

Overview of the Decision

On Monday, the U.S. Court of Appeals for the Third Circuit issued the attached opinion requiring the SEC to provide a more complete explanation for its refusal to engage in formal notice-and-comment rulemaking regarding the application of securities laws to digital assets, finding that the agency’s one-paragraph denial of Coinbase’s request for such rulemaking was insufficiently reasoned, and thus arbitrary and capricious, under the Administrative Procedure Act (APA). The decision was at least a partial win for Coinbase, which had requested that the Third Circuit require the SEC to engage in such rulemaking, and highlights the most recent example of judicial pressure on the agency to move away from what many have called the “regulation-by-enforcement” approach to crypto that defined Chair Gensler’s tenure atop the SEC.

Background

Coinbase initiated this action in July 2022 – almost a year before the SEC publicly filed an enforcement case against Coinbase in federal court in the Southern District of New York for allegedly operating as an unregistered broker, exchange, and clearing agency – by petitioning the SEC to create clear rules on how federal securities laws apply to digital assets. Coinbase argued that the SEC had not provided a consistent position while still pursuing enforcement actions. The SEC denied this request, citing other higher-priority agenda items and a preference for gathering more information through incremental (enforcement) actions. Coinbase asked the Third Circuit to review that denial under the APA, claiming that the denial was insufficiently reasoned and asking the Court to order the SEC to engage in its requested rulemaking.

Court’s Findings

The Court agreed with Coinbase that the SEC’s explanation was insufficient and remanded the issue back to the SEC for a more comprehensive explanation. Specifically, the Court found that:

1. The SEC’s disagreement with Coinbase on the application of existing securities laws to digital assets was not well-reasoned.
2. The SEC needed to explain which other regulatory efforts were more pressing and why digital asset rulemaking was not a priority despite the uptick in enforcement actions.
3. The SEC needed to clarify why it preferred incremental enforcement actions over formal rulemaking.

While the Court’s decision was a step forward for Coinbase, it was not a complete victory. The Court denied Coinbase’s request to compel the SEC to engage in formal notice-and-comment rulemaking, and found that:

1. There was no presumption in favor of rulemaking and that the SEC can continue to clarify its stance through enforcement actions.
2. The SEC is entitled to significant deference in its decision-making process (and particularly where it decides not to make a decision by engaging in rulemaking).
3. Although the SEC’s application of the Howey test to a particular digital asset may raise fair notice concerns in the context of an enforcement proceeding relating to that asset, the agency’s general position that digital assets may qualify as securities does not raise fair notice concerns in the context of a petition for broad and open-ended rulemaking.

Judge Bibas wrote a concurring opinion that provides further color on potential fair notice considerations. He questioned whether the SEC's practice of enforcing rules without clear, pre-announced guidelines violates the U.S. Constitution. In his words, “[t]he SEC repeatedly sues crypto companies for not complying with the law, yet it will not tell them how to comply. That caginess creates a serious constitutional problem; due process guarantees fair notice.” Judge Bibas suggested that the SEC's current approach leaves parties uncertain about compliance because they do not know how the “SEC applies the ill-fitting Howey test” in different circumstances and could compel a federal court in future cases to bar “enforcement-by-surprise” in order to ensure that the “SEC may not play gotcha” with the industry.

Next Steps

With the remand to the SEC now guaranteed to spill over into the Trump administration, much remains to be seen about how the agency will explain its denial of Coinbase’s petition for rulemaking in response to the Third Circuit’s directive. It is possible that the agency will provide a more fulsome explanation about its rationale that would be sufficient to comply with the Court’s ruling but still leave key questions unanswered – for example, in the oral argument before the Third Circuit, the SEC refused to confirm whether or not it views bitcoin and ether as securities, so the bar for giving additional information regarding the SEC’s approach is arguably low. That said, it is possible that the agency will reverse course in favor of rulemaking under the new administration, which is expected to be much friendlier to the industry as a whole.