The SEC Goes After Binance: a Deep Dive into the Case that Could Shape the Future of Crypto

By Filippo Zuti Giachetti

Introduction

Regulatory authorities in the United States have recently initiated an enforcement action spree against Binance.

The crucial point in such litigations resolves around the nature of cryptocurrencies and the applicability of the existing rules relating to securities and/or commodities to crypto issuers and exchanges. Interestingly, the US authorities seem to contradict themselves in answering such a question.

With this article, we will account for the most recent developments and address the most pressing issue of the nature of cryptocurrencies. In the end, we claim that the solution to bring about clarity and regulatory compliance may be available, and the United States might just have to look abroad to find interesting models to follow.

What Happened?

On 27 March 2023, the Commodity Futures Trading Commission (CFTC) [1] filed a civil enforcement action in the U.S. District Court for the Northern District of Illinois against Binance’s founder, beneficial owner, and CEO, Changpeng Zhao (CZ), Binance’s former chief compliance officer, Samuel Lim, and three entities that operate the Binance platform[2].

In short, and simplifying, the CFTC claims that Binance has offered trading to persons in the United States in digital asset commodities and related derivatives, among other financial products and services, without complying with the Commodity Exchange Act and CFTC regulations. In particular, the CFTC identifies a few crypto assets as “commodities,”[3] namely bitcoin (BTC), ether (ETH), litecoin (LTC), as well as “at least two fiat-backed stablecoins, tether (“USDT”) and the Binance USD(“BUSD”).”[4] Accordingly, the CFTC brought an action to enjoin Binance’s acts and practices and to compel their compliance with the Act. In addition, the CFTC sought civil monetary penalties and remedial ancillary relief, including, but not limited to, trading and registration bans, disgorgement, pre- and post- judgment interest.

Just two months after the CFTC’s complaint, on 5 June 2023, the Securities and Exchange Commission (SEC) filed a complaint at the United States District Court for the District of Columbia against CZ, the US entities running the Binance.US platform (to which we will refer as BAM), and Binance International Holdings (together with BAM, referenced to as Binance).

The SEC’s case relies on binance coin (BNB) and BUSD, as well as other crypto assets, being “securities.”[5]

In case you are already confused, let us reassure you that you got it right: In the space of two months, two different US regulatory agencies claimed that the same crypto asset (BUSD) is first a commodity and then a security.

The SEC went hard against Binance, alleging that “[t]his case arises from Defendants’ blatant disregard of the federal securities laws and the investor and market protections these laws provide.  In so doing, Defendants have enriched themselves by billions of U.S. dollars while placing investors’ assets at significant risk.”[6]

The day after the complaint, the SEC filed an emergency motion for a temporary restraining order (TRO) to repatriate to the US and freeze, without exceptions, USD 2.2 billion in crypto (as well as hundreds of millions in fiat currency) of BAM’s assets. The SEC alleged that it had made extensive efforts to try to ensure that during the pendency of the litigation, such assets would be custodied in the United States and under the exclusive control of BAM, rather than under the control of Binance and CZ, but Binance had failed to provide sufficient assurances that investor assets would be safe and available, without being dissipated.[7]

As an immediate reaction to the news, traders withdrew over USD 800 million from Binance in fear of being restrained from redeeming their funds and of BAM falling into bankruptcy.[8]

Given the urgency and the potential impact of such a motion, the case moved on a fast track.

On 7 June 2023, the SEC submitted the declaration of an accounting expert, Sachin Verma, in support of its TRO application. Based on the declaration, the SEC aims to show:

1. large transfers of funds to CZ, and other CZ-beneficially-owned companies, “offshore,” i.e., beyond US borders;
2. Binance’s close ties with Coinbase and Alameda Research (with almost USD 2.5 billion being exchanged between them), other crypto players under regulatory scrutiny;
3. suspicious transfers to yacht brokerage and private airplane title and escrow companies.[9]

On 12 June 2023, BAM[10], on the one side, and CZ and Binance[11], on the other side, submitted their oppositions to the SEC’s motion for a TRO.

In short, BAM alleged that the funds are secure and available, and that not only has the SEC not demonstrated otherwise but it has not even proven that customer funds are involved in the scrutinised transfers, thus failing to meet the legal standard for a TRO that would effectively terminate BAM’s business.[12] In any case, to address the SEC’s concerns, BAM proposed – as an alternative to the TRO – an order that would ensure control of the funds from the US and allow for use of the funds for the ordinary running of the business.

In the merits, BAM claimed that:

1. BNB is not a security (nor the other digital assets mentioned by the SEC) and therefore all SEC’s claims fail; and
2. the trading activity labelled by the SEC as wash-trading was legitimate as it was carried out by independent trading strategies that use automated algorithms, which are entirely independent of one another and do not have information regarding each other’s respective positions, trades, or open interests.

Binance and CZ submitted concurrent arguments to BAM, but also objected to the jurisdiction of the Court.

In addition, they claimed that the SEC is acting illegitimately by launching diffuse enforcement actions, rather than relying on formal rulemaking. Pointing to the inconsistencies between the positions of CFTC and SEC, they also alleged that: “[t]he choice that the SEC has essentially offered here—register or be sued—is arbitrary. No realistic process currently exists for cryptocurrency issuers to register the offer and sale of digital assets with the SEC or for cryptocurrency exchanges to register as a securities exchange, broker-dealer or clearing agent.”[13]

On 13 June 2023, a hearing was held before the Judge Amy Berman Jackson, who invited the parties to negotiate a consent order. As a result, a consent order was agreed upon and signed off by the judge on 17 June 2023, thus securing the funds for the duration of the trial, allowing BAM to carry out ordinary operations and Binance’s customers to redeem their funds.[14]

Why is the SEC Complaining About Binance?

The SEC claims that Binance has:

1. Unlawfully offered three essential securities market functions – exchange[15], broker-dealer[16], and clearing agency[17] – on   the Binance Platforms without registering with the SEC and without complying with the obligations imposed on registered entities.

These market functions shall be kept separate to minimise conflicts of interest and protect investors’ interests. Further, registration comes with significant disclosure obligations for the benefit of investors. For example, the SEC claims that “unregistered and non-compliant crypto asset trading platforms often do not adequately disclose that they have the ability and financial incentive to trade crypto asset securities against their own customers on the platform, putting customers on the losing side of each trade.”[18]

2. Unlawfully engaged in unregistered offers and sales of crypto asset securities, including BNB and BUSD, as well as Binance’s profit-generating programs called “BNB Vault” and “Simple Earn,” and a so-called “staking” investment scheme available on the Binance.US Platform. In so doing, they have deprived investors of material information, including the risks and trends that affect the enterprise and an investment in these securities.

3. Made misrepresentations to investors about controls they claimed to have implemented on the Binance.US Platform, while raising approximately $200 million from private investors in BAM Management and attracting billions of dollars in trading volume from investors (including retail and institutional investors) seeking to transact on the Binance.US Platform.

The SEC believes that – in order to elude US oversight – Binance’s operations in the US are carried out through a plethora of puppet companies (all beneficially owned and control by CZ, who’s final approval was needed on all significant transfer of funds) and that, while publicly claiming otherwise, they were in reality targeting US customers with their services.

In this regard, the SEC submits internal communications where Binance employees talk about this scheme in plain terms.

According to the SEC, Binance failed to implement on the US Platform the trade surveillance or manipulative trading controls they touted to investors, thus failing to prevent wash trading that artificially inflated the trading volume of crypto asset securities on the Binance.US Platform.[19]

Similarly to the CFTC, the SEC seeks a final judgment that would enjoin Binance’s acts and practices and to compel their compliance with the Securities Act, further to civil monetary penalties and remedial ancillary relief, including, but not limited to, trading and registration bans, disgorgement, pre- and post- judgment interest.

As Binance put it in their oppositions, all SEC’s claims rely on the crypto assets issued and traded by Binance being securities.[20] If such assets are not securities, all SEC’s claims go away. It is therefore crucial to understand what is a security.

What Is a Security?

As it is often the case, the relevant legislation for securities arose as a regulatory response to an historical crisis: the Great Depression, which a complete lack of regulation arguably contributed to cause, tolerating predatory and (what is now considered) fraudulent conducts in the stock market. In its aftermath, Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934 to regulate the issuance and trading of securities through registration, disclosure, recordkeeping, inspection, and conflict-of-interest mitigation requirements. The SEC was created to ensure oversight over such newly issued laws and regulations.

The Securities Act and the Exchange Act define a “security” with reference to a wide range of assets including “investment contracts.”[21] This reference to investment contracts has allowed room for flexibility in the definition of securities, and the courts have applied this concept to a variety of novel or unique investment vehicles. Hence, whilst the typical security is a company stock, courts have found that orange groves, animal breeding programs, cattle embryos, mobile phones, enterprises that exist only on the Internet, and crypto assets may also constitute a security. If an asset is a security, the company that issues and trades such an asset must register with the SEC and comply with the securities laws and regulations.

So, how can we establish whether an asset is a security? The applicable legal test (known as the “Howey test”) is provided by the old case SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946), which requires the coexistence of various elements:

1. an investment of money (i.e., the asset must be purchased or exchanged for something valuable);
2. in a common venture (there must be a common intent shared by all asset holders; in other words: the investment should be directed towards the purchase of, e.g., a “share in the profits of a large citrus fruit enterprise” rather than merely the purchase of an orange[22]);
3. with the expectation to make a profit from the work of others (i.e., non-for-profit ventures do not qualify as securities, the purpose of the venture must be to turn in profits as a passive investment, and thus not as consideration for the work carried out by the asset holder).

Complying with the securities laws and regulations can be very onerous and therefore expensive. As a result, there is a strong incentive for market participants to attempt qualify the asset they issue and trade as non-securities.

In its complaint, the SEC has labelled various crypto assets, in addition to BNB and BUSD, as securities, including SOL, ADA, MATIC, FIL, ATOM, SAND, MANA, ALGO, AXS, and COTI.

So, Are Crypto Assets Securities?

The SEC claims that “BNB was offered and sold as a security because Binance touted an investment in BNB as an investment in Binance’s efforts to create a successful crypto asset trading platform centered around BNB.”[23] And it adds that Binance employees were aware of this, as Binance’s CCO bluntly admitted to another Binance compliance officer in December 2018, “we are operating as a fking unlicensed securities exchange in the USA bro” (Emphasis added).[24]

Binance’s position is more articulated.

As a starting point, Binance claims that the SEC should have provided evidence of there being a contract, an essential element of an investment contract. Both BAM and Binance note that the SEC points principally to the initial coin offering (“ICO”) of BNB in 2017. However, as far as BAM is concerned, the companies were not even in existence at that time. Binance, on the other hand, claims that any charges related to the ICO are time-barred.[25] Since all elements of the Howey test should exist for each transaction, the SEC cannot rely on the ICO for the purpose of establishing the existence of a contract (i.e., the existence of Binance’s obligations towards BNB holders).

Binance alleges that the SEC’s claims should fail for this reason alone. However, Binance analyses the elements of the Howey test one by one, in case the Judge were to find the existence of an investment contract.

As to the first element of the Howey test, i.e., an investment of money, Binance claims – among other things – that such an investment must be committed to an enterprise. However, if we look at BNB transactions, there is not such a commitment, but rather strangers purchasing BNB from other strangers on the secondary market. In addition, Binance has often given away BNB as part of its customer programmes. Since these BNBs are indistinguishable from other BNBs, both in terms of value and claim on Binance (as BNB’s issuer; such a claim being non-existent), there is no basis to conclude that BNB was obtained through an investment of money in an enterprise.

As to the second element of the Howey test, Binance claims that the SEC also fails to show that BNB holders joined in a “common enterprise,” because BNB holders have no future interest in any Binance property, such as revenues, dividends, or anything else that would equate holding a BNB to being a shareholder of Binance. And the fungibility of BNB does not help the SEC’s case here, as it only means that BNB holders have a common interest, rather than a dependency on each other to earn profits, as it would be the case for shareholders of the same enterprise.[26]

As the third element of the Howey test, Binance claims that it has no contractual obligations to make efforts that would return a profit to BNB owners, who could consequently not reasonably expect to receive profits from Binance. In fact, BNB owners do not benefit from Binance’s profits. BNB’s value is the function of the Binance’s blockchain (BSC), which Binance does not control. BSC’s operations are overseen by a decentralised, rotating set of 29 active validators that govern the BSC by majority vote. Binance’s lack of control over BSC would be allegedly proven by (i) the fact that Binance is affiliated with only six of such validators, and (ii) a proposal from a Binance-affiliated validator was rejected by the network in December 2022.

Finally, pointing at the incongruent qualification of BUSD provided by the CFTC and SEC already highlighted at the beginning of this article, Binance claims that: “[t]o the extent BUSD fits within any existing federal regulatory framework (which [Binance]does not concede), it would be the Commodity Exchange Act (“CEA”). Similar to physical commodities, BUSD is intended for use and consumption. It meets the demand for a stable crypto asset during volatile market conditions, as users can turn to BUSD, which acts as fiat of the crypto market.”[27]

Pairing this statement with the remarks made in relation to the application of the Howey test to BNB (see footnote 26), Binance’s approach may be seen to lean towards qualifying its assets as commodities rather than securities. However, this might not be the end of the story, as the SEC may attempt to get out of a purely binary qualification of assets, in favour of a more fluid approach. This was evident at 13 June hearing, when the SEC was faced with the incongruent approach by the US regulatory agencies and it stated that: “[o]n the issue of the case brought by the CFTC, we would just highlight that courts across the country have identified that different crypto assets can be a commodity in certain contexts, can be a security in different contexts… So the BUSD product that is identified in the CFTC’s complaint is different than the one that we are alleging here.”[28] Despite this explanation, it seems rather unclear what such a difference would be in practice.

Conclusion

Regardless of who will win the case, and what the Court will decide to be a security or a commodity, it is clear that the crypto space in the US is suffering from severe regulatory uncertainty.

In its oppositions, Binance alleged that it had cooperated with the SEC since December 2020, and that the “SEC’s public statements and “guidance” have injected such confusion as to deny persons of ordinary intelligence any “reasonable opportunity to know what is prohibited.”[29] In order to provide effective guidance, Binance auspicated legislative intervention and its argument resonated with the judge, who claimed that “[Binance’s] argument has some force, that these kinds of complex legal and financial issues are better resolved through regulation or rule making than through test case litigation.”[30]

The European Union has recently followed this path with the enactment of the MiCA Regulation,[31] and the industry seems to have appreciated these efforts, as shown by booming investments in Europe-based crypto start-ups.[32]

Will the US follow suit any time soon?

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About the author

Filippo Zuti Giachetti is a dual qualified (Italy, England & Wales) International Disputes Counsel at MDisputes Srl (www.mdisputes.com), a company providing in-house counsel services for resolving and managing disputes. Filippo is an Assistant Editor to the Managing Editor of the Kluwer Arbitration Blog, an Administrator of Metaverselegal, a decentralised organisation of lawyers promoting knowledge of legal issues relating toWeb3, and the co-founder of Web3TuesDays a webinar series on Web3 and the law.

***

[1] The CFTC is the independent federal regulatory agency charged by Congress with the administration and enforcement of the Commodity Exchange Act and Regulations promulgated thereunder.

[2] See https://www.cftc.gov/PressRoom/PressReleases/8680-23.

[3] According to Wikipedia, a “commodity” is “an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them. Most commodities are raw materials, basic resources, agricultural, or mining products, such as iron ore, sugar, or grains like rice and wheat. Commodities can also be mass-produced unspecialized products such as chemicals and computer memory. Popular commodities include crude oil, corn, and gold.”

[4] See the CFTC’s complaint at page 9, emphasis added; (p. 9, emphasis added); https://www.cftc.gov/media/8351/%20enfbinancecomplaint032723/download.

[5] According to Wikipedia, a “security” is “a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction.”

[6] SEC’s complaint, p. 1.

[7] See the SEC Memorandum in Support of the Emergency Relief Request, available at

https://johnreedstark.com/wp-content/uploads/sites/180/2023/06/SECMemorandumInSupport.pdf; and the SEC’d press release, available at https://sec.gov/news/press-release/2023-103.

[8] See https://www.ft.com/content/ed6b4d90-7b18-4d05-9886-c7cdc4cfe50a.

[9] See https://www.johnreedstark.com/wp-content/uploads/sites/180/2023/06/SachinDelaration.pdf.

[10] Available at https://johnreedstark.com/wp-content/uploads/sites/180/2023/06/BamOpposition.pdf.

[11] Available at:  https://johnreedstark.com/wp-content/uploads/sites/180/2023/06/MemorandumofLaw.pdf.

[12] At the 13 June 2023 hearing, the SEC admitted that “currently the assets are not going offshore… we’re not seeing any flows of money outside of the United States” hearing transcript, page 45, paragraphs 3-9.

[13] Binance’s opposition, page 31-32.

[14] Consent order: https://www.johnreedstark.com/wp-content/uploads/sites/180/2023/06/BinanceConsentOrder.pdf.

[15] Section 3(a)(1) of the Exchange Act [15 U.S.C. § 78c(a)(1)] defines “exchange” to mean “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood, and includes the market place and the market facilities maintained by such exchange.”

[16] Section 3(a)(4) of the Exchange Act [15 U.S.C. § 78c(a)(4)] defines “broker” generally as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 3(a)(5) of the Exchange Act [15 U.S.C. § 78c(a)(5)] defines “dealer” generally as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.”

[17] Section 3(a)(23)(A) of the Exchange Act [15 U.S.C. § 78c(a)(23)(A)] defines the term “clearing agency” as “any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for comparison of data respecting the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities,” as well as “any person … who (i) acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned, or pledged by bookkeeping entry without physical delivery of securities certificates, or (ii) otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of securities certificates.”

[18] Paragraph 77 of the SEC’s complaint.

[19] One form of manipulative trading is called “wash trading.” In a wash trading scheme, a trader buys and sells the same asset between or among his or her own accounts in transactions lacking economic purpose. Wash trading is not arm’s length market activity and is not the result of market forces of supply and demand. Wash trading gives the artificial appearance of, among other things, increased trading volume, liquidity, and trading interest for the asset at issue. It may also artificially inflate the aggregate trading volume of the platform upon which the asset is being traded.

[20] See page 65 of the 13 June hearing transcript, paragraphs 4-9: “MR. MERTENS: We didn’t have to get to the issue of the operations because the operations — the statutes governing the operations only govern the operations if it’s a security. And so if they — and we do believe they do — fail on the question of whether it’s a security, everything else falls, too.”

[21] Section 2(1) defines the term “security” as to mean “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing” (emphasis added).

[22] SEC v. W.J. Howey Co. 328 U.S. 293, 299 (1946), page 328 U. S. 299. This argument is made in exactly these terms by BAM in its opposition at page 24.

[23] SEC’s complaint, paragraph 88.

[24] SEC’s complaint, paragraph 111.

[25] According to 28 U.S.C. § 2462, there is a five-year statute of limitations for enforcement proceedings.

[26] On this point, BAM compares BNB to gold (a paradigmatic commodity), where “owners of gold share a common interest in the price of gold, but that does not mean those owners are in a common enterprise that depends upon one another to earn profits on sales of gold or that they are in a common enterprise with whomever originally mined their gold” see page 25 of BAM’s opposition.

[27] See Binance’s opposition, page 26, footnote 13.

[28] See page 81 of the 13 June hearing transcript, paragraphs 7-18.

[29] BAM’s opposition, page 4.

[30] See page 77 of the 13 June hearing transcript, paragraphs 20-23.

[31] Regulation (EU) 2023/1114 of the European Parliament and of the Council of 31 May 2023 on markets in crypto-assets, and amending Regulations (EU) No 1093/2010 and (EU) No 1095/2010 and Directives 2013/36/EU and (EU) 2019/1937, available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32023R1114.

[32] See https://decrypt.co/140012/mica-vc-funding-eu-based-crypto-startups.