The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law.
Litigation and various digital asset legislative actions moved forward since our last Bi-Weekly update, as the digital asset industry prepares for the sensational (by legally unremarkable) criminal case against disgraced FTX founder Sam Bankman-Fried to dominate the headlines.
Binance has moved to dismiss the SEC’s lawsuit against both its foreign and U.S. entities and has gained support for that dismissal effort amongst industry amicus filers. Compound DAO, on the other hand, was unable to obtain the dismissal it sought in a private securities class action.
There was also legislative movement, with SEC Chair Gary Gensler on the hot seat in front of the House Financial Services Committee, and members of that Committee submitting a bill to curb SEC’s Staff Accounting Bulletin (“SAB”) 121 which required financial institutions treat digital assets held under custody for third parties as liabilities.
**Note: After this post was finalized for publication, there were important developments in the Ripple and Coinbase cases against the SEC. Those developments will be covered in the next Bi-Weekly update to be published on October 19, 2023.
These developments and a few other brief notes are discussed below.
The Compound DAO Securities Lawsuit Continues After Judge Denies Motion to Dismiss: September 20, 2023
Background: The Compound DAO securities lawsuit was allowed to continue after a Northern District of California judge denied the defendants’ Motion to Dismiss. The named Plaintiffs own less than $100 in the tokens in question, and are also named Plaintiffs in the Intuit and Juul Labs class actions. Compound previously attempted to get the case tossed under the Private Securities Litigation Reform Act.
Summary: The Motion to Dismiss focused on the lack of contractual privity between certain Compound partners and the Plaintiffs in this case, who brought their tokens on Coinbase. The Court disagreed, holding that certain statements identified raised a plausible claim to make the partners statutory sellers due to solicitations under the Ninth Circuit standard, which is broader than the solicitation standard used to dismiss claims recently in UniSwap. The Motion to Dismiss standard is an extremely high bar, so this isn’t the end of the road for those defenses available to the defendants in this action. It does, however, create a cloud of liability over DAO participants even when they are neither the issuers nor sellers of the tokens in question.
Binance Moves to Dismiss SEC Lawsuit Against Various Entities: September 21, 2023
Background: Binance Holdings Limited (“BHL”) and its founder Changpeng Zhao (“CZ”) filed a Motion to Dismiss in the SEC case against them. Its U.S. counterparts also filed their own Motion to Dismiss. Both motions stated the secondary trading in digital assets at issue do not meet the “investment contract” standard from Howey, and that the SEC’s overreach into the digital asset industry represents a violation of the Major Questions Doctrine. The U.S. entities also argue that the SEC failed to adequately plead its fraud allegations, and BHL argues that as an international entity it is jurisdictionally immune to most of the SEC’s claims.
Summary: The motions follow largely the same format at the motion for judgment raised by Coinbase. The primary arguments are that blind bid-ask secondary sales cannot be seen as an investment into a common enterprise as there is no way to know the money is going to some entrepreneurial effort, that there cannot be an “investment contract” if there is no contractual ongoing obligations on some third party, and that if this definition of “investment contract” is to be expanded to fit those asset classes then Congress must be the entity to do so rather than an administrative agency. The BHL motion also raises interesting jurisdictional challenges, and that the SEC must allege the transactions at issue are not “predominantly foreign” to survive. It will be interesting to see if a Court ever addresses what a website must do to block U.S. users to avoid U.S. jurisdiction, especially given the prevalence of VPNs. This is all occurring while the SEC and Binance continue to exchange jabs in their pending litigation regarding discovery and other issues.
SEC Chair Gary Gensler Testifies Before House Financial Services Committee: September 27, 2023
Background: SEC Chair Gary Gensler testified before the United States House of Representatives Committee on Financial Services, largely in an effort to tout his own accomplishments during his time with the agency. These include passing comprehensive private fund rules that very few were asking for (under attack as an overreach by numerous trade groups), proposing climate-related disclosures (which still hasn’t been enacted more than 18 months after originally proposed) and bringing numerous crypto-related enforcement actions (which have been a mixed bag). On the bright side, Gensler reiterated that Bitcoin does not meet the definition of security under the Howey test. On the other hand, he wasn’t willing to commit to saying that Pokémon cards, when tokenized, aren’t securities.
Summary: The GOP House Financial Services Committee’s X (Twitter) account pinned this April post to the top of their page ahead of the hearing, which demonstrates where that side of the aisle spent a good amount of their time to question the SEC head. Ire for the Chair wasn’t reserved to the Republican side of the aisle, as Democratic representative Ritchie Torres also expressed his frustration in Gensler’s inability to give a straight answer about what does and does not constitute a security. This confusion and seeming unwillingness to answer basic questions stands in stark contrast with the Chair’s frequently repeated statements that the law is clear on digital assets.
Bipartisan Uniform Treatment of Custodial Assets Act Proposed: September 27, 2023
Background: Mike Flood (R-NE), along with French Hill (R-AR), Ritchie Torres (D-NY) and Wiley Nickel (D-NC) have introduced legislation titled the Uniform Treatment of Custodial Assets Act to the House of Representatives. The bill would prohibit certain federal agencies from requiring certain institutions to include assets held in custody as a liability. This is in response to the SEC’s Staff Accounting Bulletin 121 (SAB 121) which would require banks list digital assets they held in custodial services to be kept on the banks’ balance sheets as liabilities.
Summary: SAB 121 effectively bans banking providers from providing secure custody of digital assets. If the goal is investor protection, it makes zero sense to make it prohibitively difficult for investors to deposit their assets in a trusted institution. There is no surprise as to the sponsors, as Representatives Flood and Hill have long been digital asset proponents and Representatives Nickel and Torres were two of the six Democrats who crossed party lines to vote for the FIT For 21st Century Act.
SEC Delays Decisions on Bitcoin ETFs: The SEC has delayed reaching a determination on various Bitcoin Spot ETFs which gives the agency further time to consider the applications. After Grayscale won their appeal of the SEC’s denial for their Bitcoin Spot ETF product, it is unsurprising that the SEC is delaying its determination on these similar projects.
SEC Objects to Celsius Bankruptcy Distribution: The SEC has objected to using Coinbase as a service provider in the distribution of Celsius bankruptcy assets. The SEC claims this needs to be done by a registered broker/dealer, but there are not any registered broker dealers for the assets in question, because the issuers of the assets cannot comply with reporting obligations.
Circle Files Amicus in SEC v. Binance Arguing Stablecoins Aren’t Securities: Circle has requested the Court in Binance reject the SEC’s attempts to regulate stablecoins as securities, filing an amicus brief on the issue in support of Binance. Circle, as the issuer of popular stablecoin USDC, has a vested interest in the outcome of that issue. Paradigm also filed an amicus brief on the matter, focusing primarily on the securities law arguments.
Navigating the convergence of code, smart contracts and US law reveals a dynamic terrain of ongoing legal and legislative developments in the digital asset sector. High-profile legal proceedings involving entities like Binance and Compound DAO underscore the prevailing complexities and regulatory nuances within this evolving ecosystem. Furthermore, legislative undertakings, notably by SEC Chair Gary Gensler and via bipartisan efforts like the Uniform Treatment of Custodial Assets Act, emphasize the continuous, and at times contentious, recalibration of legal frameworks surrounding digital assets and smart contracts. These developments are pivotal, highlighting the inherent intertwining of legal considerations and technological innovations in shaping the future landscape of digital assets within the US legal system.