Coinbase (NASDAQ:COIN) has been planning to launch a lending product called Coinbase Lend for months. The company would take users' cryptocurrency deposits and lend them out to borrowers, collateralizing their loans with other currencies such as Bitcoin. Depositors would earn interest on their holdings from the loans.

There's just one hiccup. Coinbase shared that the SEC had issued a Wells notice (an intent to sue) to the company over the Coinbase Lend program, alleging the product constitutes a security and needs to register as such.

Coinbase thinks the SEC is way off base, and management hasn't been afraid to let the public know as much. Chief Legal Officer Paul Grewal published a blog post, and CEO Brian Armstrong let loose on Twitter.

The fight has big potential ramifications for Coinbase, as well as crypto investors in general.

Gavel rests in front of justice scale and open law book.

Image source: Getty Images.

Is Coinbase Lend a security?

In Grewal's blog post, he says the SEC is using case law from SEC v. Howey and Reves v. Ernst & Young, but the SEC refuses to provide details of how they apply. I'm not a lawyer, but let's dive into the cases.

In the Howey case, an investment contract is defined as "a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party."

From a layperson's perspective, Coinbase Lend certainly seems to fit the definition of an investment contract in the Howey case. A person puts money into the Coinbase Lend program expecting to earn a return in the form of interest. The only way to earn that interest is if Coinbase turns around and makes money on that money by lending it out to borrowers. That's solely the efforts of the promoter, i.e. Coinbase.

The Reves case determined a note is a security based on four factors:

  1. The company sold the notes to raise capital, and purchasers bought them to earn a profit in the form of interest.
  2. The notes were offered and sold to a broad segment of the public.
  3. The public reasonably perceived from advertisements for the notes that they were investments.
  4. There was no risk-reducing factor that would make the application of the Securities Acts unnecessary (such as FDIC deposit insurance).

It can also be argued it fits the definition under the Reves case: 

  1. Coinbase is raising capital to lend to others, and purchasers expect to profit from interest payments. 
  2. Coinbase offers the product to everyone. 
  3. It's perceived as an investment. 
  4. Check the Coinbase Lend disclosure: "Coinbase is not a bank. Your loaned crypto is not protected by FDIC or SIPC insurance."

Again, I'm not a lawyer, but the SEC's case seems pretty compelling.

Coinbase's defense

Coinbase is keen to point out it's not the only player in town when it comes to crypto lending. "Other crypto companies have had lending products on the market for years, and new lending products continue to launch as recently as last month," Grewal wrote in his blog post. 

"If you don't want this activity, then simply publish your position, in writing, and enforce it evenly across the industry," Armstrong called out to the SEC on Twitter.

While Armstrong has a point that there's no official guidance from the SEC, the defense is flimsy, at best. The idea that something shouldn't be illegal just because other people have gotten away with it so far and there's no clear guideline isn't a defense.

Furthermore, competing products haven't been able to escape the law entirely. BlockFi, for example, has been targeted by three states -- New Jersey, Alabama, and Texas -- alleging the crypto-lending platform violates state securities laws.

What it means for investors

If Coinbase goes forward with Lend and the SEC goes forward with a lawsuit, it could establish a precedent that prevents many other lending programs from operating in the United States. 

The SEC's reach could even prevent decentralized finance (DeFi) protocols like Aave (CRYPTO:AAVE) and Compound (CRYPTO:COMP) from operating. The tokens of those companies responded in kind after Coinbase announced the SEC's Wells notice -- the price of each dropped sharply. However, DeFi protocols may be exempt from SEC oversight if they're sufficiently decentralized, leading to another line of legal defense for Aave, Compound, and others.

The ability to take collateralized loans is a core piece of DeFi and cryptocurrency investing. Crypto investors need to pay close attention to the dispute because the ramifications could go well beyond Coinbase's lending product.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.