Insights by: Sumit Kochar, Shivam Gera & Jaydeep Saha
BACKGROUND
The legal dispute between the U.S. Securities and Exchange Commission (SEC) and Binance has a paramount position in establishing a precedent that significantly influences the convergence of digital assets and regulatory oversight. The ramifications of the outcome extend beyond the immediate entities involved, permeating the broader cryptocurrency domain. As we delve into the complex storyline of this legal conflict, it is essential to scrutinize the fundamental allegations forming the basis of the SEC’s Complaint against Binance to the settlement of Binance with U.S. authorities.
At the crux of the SEC’s complaint against Binance, the SEC contends that Binance, being a non-U.S. entity, permitted U.S. residents to engage in the trading of tokens with characteristics akin to securities, without registering them as such offerings or operating under an applicable exemption.
The pivotal question arised, what defines a ‘security’ within the sphere of digital assets? The SEC, in its formal complaint, invoked the ‘Howey Test,’ an evaluative framework established in a seminal 1946 U.S. Supreme Court case of Howey[1], to delineate the parameters of securities within the cryptocurrency domain. According to this test, an investment contract, and consequently a security, materializes when an investment of funds occurs in a common enterprise with a reasonable anticipation of deriving profits from the efforts of others. This may not be the most suitable precedent to apply to crypto assets, and the courts will determine if this is the case. The SEC claims that certain tokens traded on Binance conform to these criteria, thereby categorizing them as securities falling within its regulatory ambit. Additionally, the SEC asserts that Binance ran afoul of U.S. securities laws by failing to register as a securities exchange or operate under a valid exemption. The supplementary allegations of commingling funds appear to evoke suspicions of a modus operandi akin to that of FTX Trading Limited (FTX), culminating in the recent market downturn.
Contrastingly, Binance vehemently refutes these allegations, contending that the impugned tokens do not exhibit the attributes of securities but rather constitute utility tokens integral to the functionality of blockchain-based platforms. Binance argued that users acquire these tokens for the sole purpose of accessing and participating in the blockchain ecosystem, as opposed to an investment motive.
HOW THE LEGAL PROCEEDINGS UNFOLDED
Allegations by the SEC in the District of Columbia against Binance Holdings Limited (Binance), BAM Trading Services Inc., BAM Management US Holdings Inc. (Binanace.US) and Binance founder Changpeng Zhao (CZ) in connection with both the Binance.com trading platform and the Binance.US trading platform were formally filed in June 5, 2023 after an extensive investigation into the exchange’s operations. The SEC contends that Binance and CZ committed multiple violations of securities laws, that the company is accused of running unregistered national securities exchanges, broker-dealers, and clearing agencies in violation of federal securities laws, including the failure to adhere to registration, reporting, and record-keeping requirements.
Furthermore, Binance is alleged to have offered and sold unregistered securities to U.S. investors, encompassing its crypto assets token such as BNB and BUSD, as well as its crypto-lending products and staking-as-a-service programs. The legal action contends that, according to U.S. law, the BNB token qualifies as a security. Token issuers based outside the U.S. should be aware that even a small number of purchasers located in the U.S. can subject them to regulation by the SEC, as they should already be aware.
The charges also include claims of misrepresentation regarding the nature and extent of Binance’s activities in the U.S., including the covert allowance of high-value U.S. customers to trade on Binance.com without proper authorization. Additionally, there are accusations of misleading investors and regulators about the independence and oversight of Binance.US, purportedly controlled by CZ and Binance behind the scenes. The company is further accused of commingling investor funds with its own and diverting them to third parties owned by CZ, such as Sigma Chain and Merit Peak Limited. Finally, Binance is alleged to have engaged in manipulative trading practices that artificially inflated the trading volume and prices of crypto assets on Binance.US.
In the U.S., the concept of investment contracts extends beyond traditional forms like cash to include digital assets. A notable case, SEC v. Shavers[2], determined that Bitcoin qualified as an investment contract and in the Binance case it is BNB and BSUD. The case involved the operation of a “Bitcoin Savings and Trust” online investment scheme, where all transactions were conducted in Bitcoin. The court reasoned that as Bitcoin was utilized for purchasing “goods and services,” it met the criteria of being considered “money” under the Howey Test’s first condition. Contrastingly out of U.S. if we see in India, the definition of securities under section 2(h) of the Securities Contract Regulation Act, 1956 (SCRA), limits its application to incorporated companies or bodies corporate. Digital assets do not meet these criteria according to the given definition. In the U.S., there is no such restriction, and the Howey Test prioritizes “common enterprises” over mere corporate entities. Notably, the flexibility of the Howey Test emphasizes substance over form in transactions. This flexibility allows courts to consider various schemes and exercise jurisdiction accordingly. Consequently, this approach has the potential to encompass digital assets based on the specific circumstances of each case.
On June 6, 2023 the SEC seeked injunctive relief, civil penalties and permanent bans on Binance and CZ from engaging in any securities-related activities in the U.S. In defense on September 21, 2023 Binance and CZ denied the SEC’s allegations and filed motions to dismiss the lawsuit. They argued that the SEC has no authority or jurisdiction over their activities, and they have complied with all applicable laws. They contend that the SEC has provided insufficient and inconsistent guidance concerning the classification of securities or securities-related activities in the cryptocurrency space. They argue that the SEC has attempted to retroactively apply vague and ambiguous rules to their operations. The defense asserts that the SEC has not demonstrated Binance or CZ’s substantial contacts or connections with the U.S., nor has it proven any targeted or solicited efforts towards U.S. investors. Furthermore, Binance and CZ dispute the SEC’s ability to establish that any of the crypto assets offered or sold fall under the definition of securities according to federal securities laws or possess characteristics indicative of securities. The defense maintains that the SEC has failed to prove allegations of operating unregistered national securities exchanges, broker-dealers, or clearing agencies in the U.S., or engaging in functions or services that necessitate such registration. Lastly, Binance and CZ assert that the SEC has not successfully shown any false or misleading statements or omissions to investors or regulators, nor have they engaged in fraudulent or manipulative conduct.
While Binance may deny the SEC’s authority, the Howey test provides a means for regulatory assessment to understand what are digital assets under the purview of securities. If we look into India, this poses a significant challenge for the Securities and Exchange Board of India (SEBI) in asserting jurisdiction over digital assets. Despite differences between crypto-exchanges and traditional stock exchanges, the prevalence of frauds and insider trading in crypto-exchanges underscores the need for regulatory action in India. Without SEBI intervention, the original purpose of the regulator to safeguard investors could be compromised. Recognizing the evolving landscape where individuals are actively investing in digital assets. To address the current regulatory gap, we argue that SEBI should reconsider the definition under the SCRA and formulate a framework that explicitly includes digital assets. Acknowledging that this process may involve extensive deliberations, we propose that, as a temporary measure, SEBI could leverage existing definitions and, where relevant, consider adopting tests employed in the U.S. This approach would provide a stopgap solution while allowing SEBI to align its regulatory framework with the dynamic nature of digital asset investments.
Further in the same date September 21, 2023, the Binance.US in response, also filed a motion to dismiss the charges against it. It claimed that it is a separate and independent entity from Binance and CZ, and that it operates a fully compliant and regulated crypto trading platform in the U.S. It asserted that the company has secured various licenses, including a money services business license from the Financial Crimes Enforcement Network (FinCEN), a money transmitter license from the New York State Department of Financial Services (NYSDFS), and a virtual currency license from the New York Department of Financial Services (NYDFS). Additionally, it has registered as a money services business with FinCEN. The company has implemented comprehensive anti-money laundering (AML), know-your-customer, and cybersecurity policies and procedures, subject to verification by independent auditors to ensure compliance. Further, it has received approval from the SEC to list and trade certain crypto assets recognized as securities, such as Grayscale Bitcoin Trust and Grayscale Ethereum Trust. Throughout the SEC’s investigation, the company has demonstrated full cooperation by providing all requested information and documents, with the exception of those protected by attorney-client privilege or trade secrets. Binance.US argued that the SEC’s lawsuit is based on unfounded allegations and irrelevant evidence, and that it should be dismissed for lack of merit and jurisdiction.
In the U.S., the Anti-Money Laundering Act of 2020 (AMLA) brought about extensive reforms to AML and counter-terrorism financing (CFT) laws. The AMLA modernizes the Bank Secrecy Act and the U.S. AML/CFT framework by codifying guidance from the FinCEN regarding digital currencies. It explicitly states that businesses providing services related to ‘value that substitutes for currency’ fall under the coverage of the Bank Secrecy Act, encompassing financial agencies and institutions such as currency exchanges and money transmitting businesses. Furthermore, the AMLA broadens the definition of ‘monetary instruments’ to include ‘value that substitutes for any monetary instrument.’ While outside of the U.S., in the United Kingdom, the Money Laundering and Terrorist Financing (Amendment) (No 2) Regulations 2022 (MLR 2022) expands the existing information-sharing regime for wire transfers to include crypto asset transfers. The MLR 2022 amends the Financial Services and Markets Act 2000, extending the Financial Conduct Authority’s (FCA) change in control regime to cover crypto-asset exchange providers and custodian wallet providers. Further, in India, the Prevention of Money Laundering Act, 2002 (PMLA) has undergone significant updates to include the regulation of cryptocurrencies and digital assets. Through a notification dated March 07, 2023, the Central Government, exercising its powers under section 2(1)(sa)(vi) of the PMLA, brought activities involving or relating to virtual digital assets (VDA), including cryptocurrencies and NFTs, under the purview of the PMLA. The Notification subjects various financial services related to VDAs, such as the exchange of fiat currency for VDAs, the exchange of different types of VDAs, and the storage or management of VDAs, to the provisions of the PMLA. This includes the provision of tools that allow control over VDAs, as well as involvement in and delivery of such services.
The SEC’ also requested for inspection against Binance and Binance.US’s software and documents, claiming that they are relevant and material to its investigation. The SEC asserted that the examination of Binance.US’s software and documents is deemed crucial in uncovering the extent and nature of the involvement and control exercised by Binance and CZ over Binance.US, shedding light on their access to customer data and funds held by Binance.US. These materials are anticipated to provide insights into the operational mechanisms of Binance.US’s platform, disclosing how it determines the eligibility and availability of crypto assets, executes trades and transfers, and manages customer complaints and disputes. Moreover, scrutiny of Binance.US’s software and documents is expected to elucidate whether the platform has adhered to federal securities laws and regulations, or if any violations or fraudulent conduct related to securities laws have transpired within its operations. The comprehensive examination of these elements is anticipated to play a pivotal role in the ongoing legal proceedings.
The SEC also requested access to Binance.US’s source code, user interface, application programming interface, database schema, data dictionary, technical specifications, user manuals, policies and procedures, contracts and agreements, correspondence and communications, financial statements, audit reports and other relevant records.
However, the SEC’s request for inspection was denied by a U.S. district court judge in New York. The judge ruled that SEC’s request was fundamentally flawed on multiple fronts. The judge deemed the SEC’s demand overly broad, burdensome, and intrusive, emphasizing that it sought access to virtually all of Binance.US’s software and documents without providing clear specifications regarding their relevance or necessity to the case. Additionally, the judge ruled that the SEC’s request was premature, arguing that the regulatory body had not fully explored less intrusive avenues, such as interrogatories, depositions, or subpoenas, before resorting to such a comprehensive information request.
Furthermore, the judge found fault with the SEC’s request, deeming it disproportionate to the needs of the case. The ruling emphasized that compliance with the broad demand would impose significant costs and risks on Binance.US while offering little or no discernible benefit to the SEC’s investigative efforts. Finally, the judge ruled that the SEC’s request was unjustified, as the regulatory body had failed to demonstrate any reasonable basis or probable cause to believe that Binance.US’s software and documents contained evidence of securities law violations or fraudulent conduct. This comprehensive judgment underscores the judge’s scrutiny of the SEC’s approach, ultimately siding with Binance.US on the grounds of the request’s overreach, prematurity, disproportionality, and lack of justification.
The judge concluded that the SEC had failed to meet its burden of showing that its request for inspection was relevant, material, necessary, reasonable, or proportional to the issues in dispute. The judge also noted that granting the SEC’s request would violate Binance.US’s privacy rights and trade secrets protections.
The ongoing efforts by the SEC to hold Binance accountable should be viewed not only as a targeted action against the exchange but also as part of a broader crackdown on the entire cryptocurrency sector. This intensified regulatory scrutiny is, in part, a response to the notable collapse of the FTX in 2022. FTX’s founder, Sam Bankman-Fried, is now facing charges including securities fraud and money laundering. The SEC has also taken legal action against the U.S.-based crypto exchange Coinbase, alleging that it operated an unlicensed securities exchange, brokerage, and clearing agency. These regulatory moves in the U.S. coincide with the challenges faced by Binance in the Netherlands and France, as well as the Financial Conduct Authority’s emphasis on the importance of compliance with the UK financial promotions regime for crypto firms. Collectively, these incidents serve as indicators of authorities globally adopting a stringent approach toward the rapidly evolving cryptocurrency sector. The lack of regulatory clarity in the crypto and digital assets space, coupled with its rapid development, has resulted in a situation where regulators are playing catch-up on a global scale, leading to gaps and inconsistencies in regulations. Despite this evolving landscape, participants in the cryptocurrency industry must ensure they are in compliance with all current regulatory obligations.
TIMELINE OF ENFORCEMENT ACTIONS AGAINST BINANCE
| February 15, 2023 | There have been reports indicating that Binance has become the subject of multiple investigations by U.S. law enforcement, with some of these investigations dating back to 2018. |
| March 1, 2023 | Binance faced scrutiny from the U.S. Congress, with Senators Elizabeth Warren, Chris Van Hollen, and Roger Marshall sending a letter to CZ and Binance.US CEO Brian Shroder. The letter sought answers to various allegations and requested access to the companies’ balance sheets. Dissatisfied with the responses received, the senators subsequently accused the executives of providing misleading information. |
| March 27, 2023 | The Commodity Futures Trading Commission (CFTC) initiated legal action against CZ, along with Chief Compliance Officer Samuel Lim and Binance. The lawsuit includes seven counts related to trading irregularities and market manipulation, following a CFTC investigation that reportedly commenced in 2021. CZ vehemently refuted the charges. |
| June 5, 2023 | The Securities and Exchange Commission filed suit against Binance, Binance.US and CZ on June 5 with 13 charges, including unregistered securities sales, allowing U.S. customers to use the Binance exchange, intermingling customer and corporate funds, and wash sales. |
| August 14, 2023 | Binance.US sought a protective order against the SEC, accusing it of launching a “fishing expedition” in its discovery process. The exchange insisted it was acting in good faith in the process. |
| September 13-14, 2023 | Binance.US underwent a significant downsizing, laying off approximately one-third of its workforce, totaling around 100 individuals. Additionally, CEO Shroder left his position. The Securities and Exchange Commission (SEC) raised concerns with the court, citing a lack of cooperation from Binance during its discovery process. |
| September 19, 2023 | Binance.US achieved a small triumph as the court denied the SEC access to the exchange’s software. Instead, the judge recommended that the SEC provide more specific details in its discovery requests. |
| October 23, 2023 | Binance filed a motion to dismiss the CFTC’s suit. If the CFTC prevailed, it “would allow it to regulate any activity in cryptocurrency […] related to a derivatives product” worldwide, Binance said. “Congress did not make the CFTC the world’s derivatives police, and the Court should reject the agency’s effort to expand its territorial reach beyond what is permitted by the law,” it added. |
| October 26, 2023 | The Bloomberg Billionaires Index dropped CZ from 11th place among the richest people in the world to a somewhat more modest 95th. His personal wealth was said to have been reduced from $96.9 billion to $17.3 billion. His standing had risen to 68th place by the November list, however the same day, Senator Cynthia Lummis and Representative French Hill called on the Justice Department to move against Binance and Tether for enabling sanctions evasion. This was two weeks after Binance froze accounts linked to Hamas. |
| November 21, 2023 | Indictments were filed against Binance and CZ in Washington state on November 14 by the U.S. Government. The documents were unsealed on November 21, coinciding with CZ’s resignation from Binance as part of the settlement deal. |
BINANCE SETTLEMENT WITH U.S. GOVERNMENT
On November 21, 2023, Binance admitted guilt and consented to a payment exceeding $4 billion to resolve the Justice Department’s investigation into various breaches related to the Bank Secrecy Act (BSA), failure to register as a money transmitting business, and the International Emergency Economic Powers Act (IEEPA).
CZ, also pleaded guilty to the failure to maintain an effective anti-money laundering (AML) program, a violation of the BSA, and subsequently resigned as CEO of Binance.
The Treasury Department, acting through the FinCEN and the Office of Foreign Assets Control (OFAC), took unprecedented actions against Binance and its affiliates for infringements of U.S. anti-money laundering and sanctions laws.[3] Binance has agreed to settle with FinCEN and OFAC for $3.4 billion and $968,618,825, respectively. This development underscores the Treasury Department’s commitment to robust enforcement measures within the virtual currency industry. Entities relying on the U.S. financial system, regardless of their location, must ensure compliance with anti-money laundering, sanctions, and other U.S. national security obligations, particularly for money services businesses (MSBs) subject to special reporting requirements.
Binance is alleged to have violated multiple sanctions programs while matching and executing virtual currency trades on its online exchange platform, engaging in activities that facilitated prohibited transactions or provided prohibited goods and services to blocked users or embargoed destinations. Specifically, the conduct of Binance is said to have contravened sanctions programs targeting Iran, Syria, North Korea, Cuba, the Crimea region of Ukraine, and the Donetsk and Luhansk People’s Republics.
Furthermore, Binance is accused of violating FinCEN requirements by operating as an unregistered MSB and neglecting to report over 100,000 suspicious transactions to FinCEN through suspicious activity reports. These transactions were related to various illicit activities, including terrorist financing, ransomware, child sexual abuse materials, dark net markets, and scams.
OFAC determined that Binance’s apparent violations were egregious due to the company’s demonstrated awareness of and willful disregard for U.S. requirements. The penalties were augmented as these apparent violations were not voluntarily disclosed.
In addition to the substantial monetary settlement, the settlement agreements impose a range of monitoring and compliance commitments on Binance. The company has agreed to enlist an independent monitor for the next five years and implement a sanctions compliance program aimed at minimizing the risk of further violations. This program includes conducting a risk assessment, implementing internal controls, undergoing testing and auditing, providing training, ensuring Binance’s complete withdrawal from the U.S., and more.
VIEW ON THE SETTLEMENT
The Binance settlement serves as a valuable source of lessons for the digital assets industry at large. The key takeaways underscore the paramount importance of adopting proactive measures to ensure regulatory compliance and cultivating a steadfast commitment to a culture of adherence to rules and regulations.
The positive practices highlighted encompass hiring of competent compliance personnel, for constructing a robust framework that aligns seamlessly with legal requirements. Further, the cautionary note against permitting automated processes, such as “location-agnostic” algorithms, to operate without due consideration for AML and sanctions compliance emerges as a critical lesson. Additionally, the recommendation to tailor AML and sanctions compliance programs to the unique nature, sophistication, and scale of operations stands out as a best practice for ensuring effectiveness. This encompasses the timely design and implementation of such programs, coupled with the necessary registrations, including the designation as a Money Services Business (MSB) where required.
The overarching message resonates clearly i.e., the digital assets industry must proactively embrace vigilance and adaptability in navigating the intricate regulatory landscape. Prioritizing compliance and responsibly leveraging technology are essential strategies that empower entities to effectively mitigate risks, instill trust, and successfully navigate the complexities of the regulatory environment.
[1] SEC v. Howey Co., 328 U.S. 293 (1946)
[2] 13-cv-00416 (United States District Court for the Eastern District of Texas)
