Second Circuit to Hear Critical Interlocutory Appeal in Crypto Securities Enforcement Action

Client Alert

January 09, 2025

In a significant development for the digital asset industry, U.S. District Judge Katherine Polk Failla of the Southern District of New York certified for an interlocutory appeal her prior Order finding crypto assets fall within the purview of the SEC. This is an extremely rare procedure that allows the U.S. Court of Appeals for the Second Circuit to address a critical question: Whether, under the factors set forth by the United State Supreme Court in its seminal Howey decision, crypto transactions can be deemed to be “investment contracts” and therefore can be regulated under the federal securities law. This appeal would be the first time a federal appellate court weighed in on these issues and could have sweeping implications for the regulatory treatment of digital assets, the nature of the Howey test itself and the future of crypto markets in the U.S.

Background

The Securities and Exchange Commission (SEC) commenced an enforcement action against Coinbase, alleging that the platform engaged in activities requiring registration as a securities exchange, broker and clearing agency. Coinbase had spent years unsuccessfully trying to find a path to registration with the SEC despite its vehement insistence that tokens and other cryptocurrencies traded on the site were not securities, and therefore outside the regulatory mandate of the SEC. The SEC did not approve the registration of Coinbase as a broker-dealer and instead brought forth a lawsuit alleging failure to register as a broker-dealer while performing brokerage activities in securities. Coinbase has forcefully disputed the SEC’s position and moved for a judgment on the pleadings, arguing that the digital assets at issue are not securities because they lack the characteristics of traditional investment contracts. Judge Failla disagreed and held that the crypto assets at issue could plausibly be securities and subject to regulation. However, the January 7^th Order now allows the Second Circuit to weigh in on the issue and Judge Failla, herself, has held that ‘substantial ground for difference of opinion” exists. While the Second Circuit must also technically agree to hear this interlocutory appeal as well, we expect they will given Judge Failla’s decision and framing of this case as implicating important legal issues. In fact, the outcome of the appeal, barring another appeal by a party to the United States Supreme Court, would tip the outcome in the underlying case.

The Court's Decision

Judge Failla's approval of the interlocutory appeal is noteworthy, given the rarity of such appeals. By allowing an interlocutory appeal, the Second Circuit gets to address the issue while the case is still pending. Typical federal court procedure would not allow an appeal until after a final judgment is entered in the case. The underlying case, SEC v. Coinbase, is also stayed while the Second Circuit hears Coinbase's interlocutory appeal. The court makes clear that the case presents a controlling question of law with substantial grounds for difference of opinion, in stark contrast to the SEC’s repeated position in lawsuits and in the press that the securities laws are clear in how they apply to crypto. In fact, Judge Failla states explicitly that "there is indeed substantial ground to dispute how Howey is applied to crypto assets and the role of the surrounding digital ecosystem in that analysis."

This point regarding the SEC's "ecosystem" theory in particular is worth noting—the court also says it is an issue of first impression for the Second Circuit.

Implications for Digital Assets

This development holds substantial implications for the digital asset sector in the US:

Regulatory Clarity and Legal Precedent: The Second Circuit is a highly influential appellate court with respect to matters of commerce and securities law. A definitive ruling from the Second Circuit could establish clear guidelines on the classification of digital assets, influencing how digital assets are regulated and traded. Any decision could be appealed to the Supreme Court (which would have to agree to hear the appeal), which would have the opportunity to revisit the Howey test itself as it pertains to crypto. Remember that the Howey case dates back to 1946 and dealt with an orange grove collective, and the analogy to digital assets is strained at best.

Other SEC Lawsuits: The new SEC leadership, under Chair-designate Paul Atkins, could use this decision to ask for voluntary stays in all other pending enforcement actions against Binance, Kraken and others that are based on the same legal theories that Judge Failla noted were subject to substantial dispute. Notwithstanding the outcome of the Coinbase appeal, we expect that an Atkins-led SEC would stand down on many of the existing cases on behalf of the government. It would be awkward if the Second Circuit rules for the SEC, and the SEC nonetheless stands itself down for political or policy reasons. Absent new legislation or a Supreme Court decision to the contrary, that could effectively put in place a policy that crypto exchanges, despite dealing in securities, would not need to register as brokers.

Political Overlap: This decision provides further support for the emerging bipartisan consensus that crypto regulation is unclear and detrimental to US economic interests. Judge Failla’s order, paired with the incoming pro-crypto Trump administration and a Republican Congress that has promised to move pro-innovation crypto legislation early in the 119^th Congress, enhances the prospect for new legislation that finally provides clarity on the questions of whether crypto assets are ‘securities’ or ‘commodities’ and on which regulatory authority is charged with oversight. Congress is free, after all, to overrule Howey by subsequent legislation amending the securities laws to carve out digital assets from the definition of securities or exempting exchanges from registration and compliance with the extensive broker-dealer regulatory scheme if the exchange solely deals in digital assets. Note that Congress has tried and failed on multiple attempts over the past two administrations to do just that. We do believe there is new momentum to move forward with clear guidance and legislation unlike any other time before.

Market Impact: Institutional investors who have sat on the sidelines over the last three years of regulatory attack and uncertainty will be far more likely to move into the digital asset space as the political and judicial climate continues to improve for crypto. Well-known blue-chip cryptocurrencies such as Bitcoin, Ethereum, Solana, Ripple, Litecoin and others will continue to enjoy mainstream investment popularity, but the outcome of the appeal and any new regulations will possibly be a strong green light for developers of new protocols and tokens and may pave the way for the U.S. to stay at the forefront of digital asset development.