The biggest legal news of the past two weeks was the Coinbase loss on two of three categories of claims at the Judgment on the Pleadings stage of litigation against the SEC. While it is rare to win at such an early stage in litigation, the wording of the decision raises further questions about what an “ecosystem” is and why Solana apparently has such an ecosystem to turn transactions of Solana into arguably securities transactions, but Bitcoin does not.

There were also determinations in long pending cases against FTX founder Sam Bankman-Fried and Terraform Labs founder Do Kwon, with the former being sentenced to nearly 25 years in prison, and the latter being found liable for securities fraud. Finally, there was a briefing submitted on the important issue of when the development of cryptocurrency software can be criminalized if that software is used by unrelated malicious third parties.

These developments and a few other brief notes are discussed below.

SEC Hit with Another Declaratory Action Case, This Time Regarding Airdropped Tokens: March 25, 2024

Background: Beba LLC and the DeFi Education Fund have sued the SEC for a declaratory judgment regarding Beba’s planned token airdrop for use in obtaining discounts on certain handmade goods. You can read the lawsuit here. You can also read the thread by the DeFi Education Fund breaking down the lawsuit here. “Together with Beba, DEF seeks a declaration from the Court that the SEC violated the Administrative Procedure Act when they adopted their policy that nearly all digital assets themselves are investment contracts and nearly all digital asset transactions are securities transactions.”

Summary: A few weeks ago it was exchange platform LEJILEX who sued the SEC for a declaratory judgment. Now it is Beba with the support of the DeFi Education Fund. There will likely be more to follow, especially if these cases can be shown to make it past jurisdictional defenses on a Motion to Dismiss. After years of the SEC bringing cases against tiny projects with limited funding (like LBRY), it will be interesting to see projects without the baggage (pun intended in the case of Beba, a luggage manufacturing company) of bad facts that can be argued simply on the basis of law.

Coinbase (mostly) Fails to Obtain Dismissal at Judgment on the Pleadings Stage: March 27, 2024

Background: The Court overseeing the SEC v. Coinbase lawsuit ruled against Coinbase on 2 of the three categories of alleged violations. The Court found that the SEC sufficiently pled there is a cryptocurrency “ecosystem” to support horizontal commonality for the Investment Contract analysis for at least some of the 12 digital assets at issue. The Court also held that the risk of loss in the staking program and the consideration in the form of the crypto asset to be staked was sufficiently alleged to survive at this stage in litigation. Finally, while ruling digital assets were not of such importance as to invoke the Major Questions Doctrine, the Court did rule that Coinbase providing a front end to DeFi platforms through the Coinbase Wallet was not sufficient to fall afoul of securities laws and the Court dismissed that claim.

Summary: Even after seemingly favorable questions by Judge Failla at oral arguments, Coinbase’s own head of legal didn’t expect an outright win, so this was as expected. But still, the decision seemed to take liberties with the facts such as stating that token issuers “maintain” those tokens, that every blockchain has a native token (which all the blockchains at issue in this litigation do, but isn’t always the case), and defining “ecosystem” as everybody but the users of digital assets (who are arguably the most important parties in determining a digital asset’s value). Still, the wallet ruling is pretty massive for people working in DeFi or on the front end applicable to those DeFi platforms. This is the first ruling where a court has held that accepting transaction-based compensation for digital asset transactions does not automatically make the front-end interface a broker-dealer. The staking ruling, however, could have large implications outside of just digital assets. If staking is a security, it is possible the same logic would make the use of Turo, Airbnb, and countless other applications which make the technically complex process of earning money on assets easier for consumers' securities transactions.

Sam Bankman-Fried Sentenced to 25 Years in Prison: March 28, 2024

Background: FTX founder Sam Bankman-Fried (“SBF”) was sentenced to twenty-five years in prison after previously being convicted for seven counts of fraud and conspiracy related to his actions which led to FTX’s collapse. Judge Kaplan recommended that Bankman-Fried serve his time in a minimal or medium-security facility, ideally close to San Francisco, CA, so he can be near his family.

Summary: There will be appeals and all the co-conspirators who testified against SBF will also need to be sentenced, but this brings an end to one of the darkest stories in crypto. It is worth noting, that SBF’s crimes were possible because many of the exchange’s activities were off-chain, differentiating from DeFi where liquidity is always known. While there were some interesting exchanges during the sentencing hearing, it would be nice to put this whole ordeal in the rearview mirror.

Amicus Filed in Criminal Case Against Tornado Cash Developer: April 5, 2024

Background: Roman Storm is currently facing charges for his role in creating the Tornado Cash protocol and front-end access to that protocol, a digital asset mixing service famously used by North Korean hackers. He recently moved to dismiss those charges. The DeFi Education Fund, Coincenter, and the Blockchain Association have all filed amicus briefs in his support, arguing that criminalization of creating computer programs that can be used for legitimate and illegitimate purposes should not be a crime, and goes against prior FinCEN guidance.

Summary: As stated by the DeFi education fund: “There is nothing illicit about the desire for financial privacy—it is a fundamental right deeply rooted in the history of our nation and codified in the First and Fourth Amendments to the U.S. Constitution, among many other places in federal law.” It seems like a stretch to prosecute a software developer for someone else’s misuse of the neutral technology he worked on. While there certainly needs to be steps to prevent illicit use of digital assets in finance, there needs to be a line between criminality and the creation of a digital safe that can be used by criminals or legitimate actors alike.

Do Kwon and Terraform Labs Found Liable in SEC Fraud Case: April 5, 2024

Background: A jury has found Do Kwon and Terraform Labs liable for misleading investors in a scheme that led to the collapse of the Terra/Luna algorithmic stablecoin and started the contagion which eventually resulted in the collapse of 3AC and FTX. The jury found that Do Kwon acted intentionally to defraud investors, which makes it all the more likely that criminal charges will be brought as well.

Summary: Bad facts make bad law, and Do Kwon/his company did some undeniably bad things which caused a negative ripple across the industry and led to the eventual collapse of FTX and others. While the Court was likely legally correct that what Terraform labs did constitute securities law violations, there were some inconsistent rulings in this case such as the Court instructing the jury that the tokens were, in and of themselves, securities, despite earlier ruling to the contrary at the Motion to Dismiss stage. That makes it likely the case will be appealed and be the first to reach the Second Circuit Court of Appeals on this issue.

Briefly Noted:

Coinbase Wins at Second Circuit: In the Coinbase civil suit, Coinbase won at the Second Circuit Court of Appeals with the Court holding that “The repetitive, conclusory allegations that Plaintiffs “had one or more losing transactions” in various Tokens are insufficient to plausibly allege a contract that gives rise to rescission under Section 29.” This case is more inartful pleading than the validity of secondary market sales constituting securities transactions, but a win is a win.

SEC Leaders Exchange Barbs on Digital Assets at SEC Speaks: Commissioner Hester Peirce had sharp statements against her agency’s approach to digital assets. Meanwhile, Director of Enforcement Gurbir Grewal accused the industry of non-compliance. It is clear from both that the current status quo is not working, so it will be interesting to see whether Peirce’s advocacy for tailored rules vs. Grewal’s advocacy for industry ceasing to exist in the United States if it cannot comply with existing rules wins in the end.

House Republicans Ask SEC Commissioner About Status of Ether: House Republicans sent a sternly worded letter to Gary Gensler asking for clarification on the SEC’s position as to the regulatory classification of ETH, and the SEC’s position regarding Prometheum’s announcement that it intends to custody ETH (as a security) on behalf of customers.

Custodia Bank Fails to Obtain Master Account: Custodia Bank (mostly) lost its fight with the Federal Reserve to get a master account. It’s unclear why the business model of “we will keep 100% reserves and just charge a small fee rather than loaning out your money and keeping partial reserves” is not an acceptable way to run a bank. But it is clear that the Courts are giving the Federal Reserve wide latitude to make such determinations.

Utah Enacts Law Prohibiting Compelled Production of Private Keys: On March 18, 2024, the Utah Governor signed into law H.B. 118 Prohibition of Production of Private Keys. The law prohibits compelling an individual to produce the “private keys” for digital asset wallets, instead requiring legal authorities to seek the transfer of the assets contained therein. This makes sense, as the producer of private keys still has access to the contents of a wallet, making the production of those keys inefficient and a security risk for all parties involved.

MiCA DeFi Rules Could Require Registration by Protocols: The European Commission is evaluating the DeFi industry to determine whether protocols should be required to obtain a MiCA license to operate. The report on the feasibility of DeFi regulations is to be completed by December 30, 2024. “MakerDAO co-founder Rune Christensen noted that the rules could place some DeFi interfaces, such as decentralized exchanges, under licensing requirements.”

Conclusion:

The landscape of digital assets and cryptocurrency regulation has been significantly shaped by recent legal developments, as highlighted in the past two weeks. The Coinbase case against the SEC, which challenged the regulatory framework applied to digital assets, underscores the evolving definition of what constitutes security within the blockchain ecosystem. This, coupled with high-profile legal actions against figures like Sam Bankman-Fried and Do Kwon, illustrates the complex interplay between innovation, regulation, and enforcement in the sector.

Additionally, the debate over the criminal liability of developers for the misuse of their software by third parties raises critical questions about the future of digital privacy and the role of regulation in fostering both innovation and consumer protection.

As the industry continues to navigate these turbulent waters, the outcomes of these cases will undoubtedly set precedents that shape the regulatory landscape for years to come, balancing the scales between innovation and the need for regulatory oversight to protect investors and maintain market integrity.