Crypto Faces Legal Reckoning as SEC Prepares Action Against Coinbase

Coinbase has taken an increasingly defiant stance, publicly criticizing the SEC and urging regulators to write new rules for crypto rather than enforce existing ones. Coming into SEC compliance, the firm says, would effectively mean shutting down its business. 

“The implications for the crypto business are very significant,” said Neel Maitra, a partner at Wilson Sonsini Goodrich & Rosati who previously served at the SEC as a crypto specialist. “Much will depend on the precise form that the SEC’s potential action takes.”

Regulators have come under intensifying pressure to crack down on crypto since the collapse of FTX, whose founder, Sam Bankman-Fried, aggressively lobbied policy makers last year. Crypto-friendly lawmakers blasted the SEC for failing to spot the problems in FTX before it blew up—though some of them had also criticized the agency’s investigations earlier last year.

Since 2021, Mr. Gensler has warned platforms such as Coinbase that they were breaking the law by letting investors trade cryptocurrencies that should have been registered as securities, the legal category that includes stocks and bonds. He has demanded the firms comply with SEC rules by registering as securities exchanges and separating parts of their business that create potential conflicts of interest.

Now, the SEC is preparing to test Mr. Gensler’s view in court. While a lawsuit could still be many months away—or averted entirely—the formal process that began this week could potentially end in a court’s ordering Coinbase to shutter or restructure significant parts of its business in the U.S. 

SEC staff say they could seek remedies including injunctions, cease-and-desist orders and fines—penalties that could threaten the company’s ability to operate in its current form. If it registered as a securities exchange, as Mr. Gensler has demanded, Coinbase would be able to list only SEC-registered securities. Yet no prominent cryptocurrencies—nor any of the 242 assets currently listed on Coinbase—are currently registered with the agency.

Chief Legal Officer Paul Grewal said Wednesday that Coinbase representatives had met with the SEC more than 30 times over nine months and spent millions of dollars working on proposals to register parts of its business. That process appeared to end when the SEC canceled a meeting with Coinbase in January and shifted to enforcement, he said. 

After disclosing the Wells notice—the term for the letter a regulator sends to notify a respondent of charges it intends to file—on Wednesday, Coinbase executives expressed disappointment but said they had been preparing for litigation.

“We’re very, very confident that we’re going to be able to defend these claims, not just for Coinbase but for crypto as a whole,” Mr. Grewal said Thursday. 

The firm has accused the SEC of stifling innovation and has spent millions of dollars lobbying Congress in hopes of bypassing regulators through new legislation. It has also stepped up its political organizing, seeking to rally its users to write lawmakers and donate to pro-crypto candidates.

The crypto industry increasingly sees Congress as its best hope for continuing business as usual in the U.S., where most financial investments that depend on third-party efforts are covered by SEC regulations. Mr. Gensler has said the vast majority of crypto tokens, with the exception of bitcoin and perhaps a limited number of others, are securities.

Fighting the SEC could be expensive at a time when Coinbase’s business is already under pressure from a downturn in crypto markets. Ripple Labs Inc., a crypto firm that is defending itself against an SEC lawsuit filed in late 2020, expects to rack up $200 million in legal bills before the case is decided, according to people familiar with the matter.

The first cryptocurrency, bitcoin, was designed to be a peer-to-peer payment system. But so-called centralized exchanges—platforms operated by firms such as Coinbase, Binance and the now-defunct FTX—have become the keystones of the crypto industry. By using a combination of bank accounts and blockchain addresses, they serve as the main access points for individual investors to trade dollars for cryptocurrencies, or vice versa. That is why Mr. Gensler shifted the SEC’s enforcement focus to such intermediaries shortly after taking the helm. 

“What we’re focused on in crypto is compliance,” Mr. Gensler told reporters on March 15, adding that investors should have the same protections in crypto as they enjoy in the stock market. “Each of these token operators and intermediaries, consulting with their advisers, know full well what it means to have full, fair and truthful disclosure.”

To date, the SEC’s enforcement actions in crypto have been more incremental. It has brought dozens of cases against individual token issuers for offering unregistered securities. In the past year or so, it has sued or settled with several crypto lenders, and in February the SEC settled with Coinbase rival Kraken over the firm’s so-called staking product.

“Your average American who buys or sells cryptocurrencies, they tend to do that through Coinbase,” said Kristin Smith, head of the Blockchain Association, a trade group of which Coinbase isn’t a member. “This is the largest target that the SEC could go after.”

The SEC notice comes as disparate parts of the federal government—from the White House to the Federal Reserve—have signaled growing skepticism of crypto as an asset class following the sudden collapse of FTX in November.

On Tuesday, President Biden’s annual economic report to Congress included a 35-page section focused heavily on crypto’s risks to investors and the industry’s noncompliance with regulations. “Crypto assets currently do not offer widespread economic benefits,” the report said. “They are largely speculative investment vehicles.”

Write to Paul Kiernan at paul.kiernan@wsj.com