SEC Plans Lawsuit Against Coinbase, According to Exchange

By warning Coinbase about a potential lawsuit, the SEC is setting its sights on one of the biggest names in crypto, a publicly traded company that has helped bring tens of millions of customers into the digital-currency markets since it was founded in 2012.

A lawsuit would represent SEC Chair

Gary Gensler’s

biggest step to assert his agency’s jurisdiction over crypto. If Coinbase prevailed in a lawsuit, it would embolden the crypto industry’s claims that Mr. Gensler has overreached and that virtual currencies shouldn’t be subject to U.S. securities laws.

The notice concerned several aspects of Coinbase’s business, including assets listed on its crypto exchange, its staking service Coinbase Earn and its wallet service, the company said.

Coinbase Earn is a program that allows customers to earn rewards on their digital assets by staking, a process in which crypto investors lock up their coins to facilitate transactions on the underlying blockchain network. A crypto wallet holds digital tokens for users.

“We are prepared for this disappointing outcome and confident in the legality of our assets and services,” Coinbase Chief Legal Officer

Paul Grewal

said. “If needed, we welcome a legal process to provide the clarity we have been advocating for and to demonstrate that the SEC simply has not been fair or reasonable when it comes to its engagement on digital assets.”

An SEC spokeswoman declined to comment.

Coinbase’s stock fell down almost 12% after hours after falling 8% in regular trading. Crypto-related stocks and bitcoin have had a rally in recent weeks, but turned negative following the Federal Reserve’s rate increase announcement on Wednesday.

An SEC lawsuit against a crypto exchange carries potentially existential consequences since regulators can seek injunctions that would block the company from activities the SEC argues violate the law. Despite a yearslong crackdown on crypto sales and trading, the SEC has sued only a few crypto exchanges. 

In a message he posted to Twitter late Wednesday, Coinbase CEO

Brian Armstrong

referred to the change in the SEC’s position toward his company over the past two years. The SEC allowed Coinbase to go public in 2021, he wrote, including after reviewing its disclosures that “clearly explained our asset listing process and included 57 references to staking.”

Coinbase shares debuted on public markets on April 14, 2021, three days before Mr. Gensler was sworn in as SEC chair. While the SEC took enforcement actions against crypto companies during the Trump administration, the agency has gone after bigger companies since Mr. Gensler took over.

The SEC on Wednesday sued crypto entrepreneur Justin Sun and settled with celebrities Lindsay Lohan and Jake Paul over money they made by touting Mr. Sun’s business without making required disclosures.

The SEC’s enforcement process gives companies the right to respond to the SEC’s Wells notice and argue why regulators are wrong. Regulators have six months to decide whether to proceed with a lawsuit after delivering a Wells notice, although that deadline can be extended.

For now, the SEC’s notice doesn’t require any changes to Coinbase’s current products or services, Mr. Grewal said.

The scope of an SEC lawsuit could change over the coming months as regulators and lawyers for Coinbase spar over the investigation, said Marc Fagel, a former director of the SEC’s San Francisco office. Companies such as Coinbase sometimes try to settle after receiving Wells notices if they can limit the damage to their business, he said.

In February, rival crypto exchange Kraken agreed to stop offering staking services to U.S. customers and pay $30 million in penalties to the SEC as part of a settlement with the agency.

The SEC alleged in a separate lawsuit filed in July that Coinbase had listed at least seven digital assets that should have been registered with the SEC before they were sold or traded. The SEC made the allegations as part of an insider-trading lawsuit against a former Coinbase employee, Ishan Wahi, who tipped his brother to cryptocurrencies that would be added to Coinbase’s trading platform, which instantly boosted their value.

Mr. Wahi in February pleaded guilty to criminal charges filed by Manhattan federal prosecutors. But he is fighting the SEC, which didn’t name Coinbase as a defendant in its lawsuit against Mr. Wahi, Mr. Wahi’s brother and another trader.

The SEC’s claims in the Wahi case about tokens that Coinbase listed could be part of its investigation of the crypto company. Coinbase, which conducted its own internal investigation of Mr. Wahi’s trading, said in July after the SEC filed its lawsuit: “Coinbase does not list securities. End of story.”

Alleging that Coinbase listed assets that should have been regulated as securities is “the next logical step for the SEC to look at,” Mr. Fagel said. But bringing a lawsuit alleging those claims “is a more complicated case because for each token, the SEC has the burden of showing it is a security,” he added.

Coinbase went public on

Nasdaq Inc.

in April 2021, a market debut that appeared to be a major mainstream endorsement of crypto and fueled a big run-up in the price of bitcoin. The company noted in its blog post Wednesday that the SEC signed off on its registration statement at the time, and its staking and exchange businesses had remained largely the same since then.

The Wells notice grew out of an SEC investigation that Coinbase disclosed last summer, the company said in its blog post. Coinbase said it sought to resolve the agency’s concerns by registering part of its business with the SEC, and it met with the agency’s staff more than 30 times as it tried to hash out a way that it could become registered. But in January the SEC canceled a meeting with Coinbase and said it would be shifting back to an enforcement investigation, the company said.

“We now understand that there is disagreement within the Commission itself on how to proceed with a registration path,” Coinbase said.

Write to Alexander Osipovich at alexo@wsj.com and Dave Michaels at dave.michaels@wsj.com