On June 5, 2023, the Securities and Exchange Commission (SEC) sued Binance and its CEO Changpeng Zhao (CZ) for billions of dollars. This week, the SEC reiterated and clarified its claims in a rebuttal to Binance’s formal motion to dismiss that lawsuit.
The SEC’s lawsuit alleges that Binance raised money by selling its two tokens, BNB and BUSD, in illegal securities offerings to many US investors. That fundraising, plus untold millions from selling other unregistered securities, helped it earn at least $11.6 billion in revenue.
Explaining its reasoning, the SEC focused on the Howey Test, which US courts commonly use to determine whether someone illegally sells crypto assets. The Howey Test refers to a 1946 US Supreme Court ruling, SEC v. W.J. Howey Co. Deciding in the SEC’s favor, the Supreme Court defined an investment contract as a transaction that meets these four conditions:
- An investment of money,
- Into a common enterprise,
- With the reasonable expectation of profit,
- Derived from the efforts of others
The SEC centered part of its argument around the courts’ flexible approach to interpreting the Howey Test in previous cases that involved alleged securities. For instance, it cited three cases in which courts ruled that “money” can take several forms, not just fiat currencies like US dollars. For instance, goods and services for which someone would pay monetary value can be traded in-kind for securities.
Binance says it doesn’t list securities, despite lawsuit
The SEC used decades of legal precedent to counter Binance’s claims that it does not list securities. It clarified that an investment contract is a purposeful catch-all term that encompasses a broad swathe of instruments that promoters use for fundraising.
Indeed, the SEC summarized decades of court rulings in its favor: “Congress defined security broadly to embody a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits. Courts have found a variety of novel or unique investment vehicles to be investment contracts, including those involving orange groves, animal breeding programs, cattle embryos, mobile phones, enterprises that exist only on the Internet, and crypto assets.”
The SEC alleges that BNB tokens’ price could change depending on Binance’s efforts and fortunes, making it an enterprise with “vertical commonality.” It rejects Binance’s claims that the long-term performance of BNB is ultimately independent of Binance’s efforts.
Binance lawsuit involves vertical commonality
‘Vertical commonality’ exists when the fate of token holders is aligned with the fate of the leaders of the token. The ‘vertical enterprise’ for BNB involves token holders keeping the price high enough so that Binance executives can pay for development of the digital asset ecosystem, onboard new users through Binance.com, promote BNB through Binance’s platforms and marketing channels, and fund development initiatives for BNB’s blockchain.
In this way, all of Binance executives’ efforts are perfectly financially aligned with retail BNB token holders. Indeed, Binance executives are themselves the biggest BNB token holders. As a result, all BNB token holders share vertical commonality with Binance executives.
The SEC cited the BitConnect case, in which a court ruled that the BitConnect “platform itself was the common enterprise.” In BitConnect, members had vertical commonality; the value of the BitConnect token (BCC) depended on the aligned efforts of BCC token holders and promoters.
Preorders on Kickstarter are not securities
To clarify that investment contracts do not encompass all financial offerings, the SEC cited a case where the profits “must, in conformity with ordinary usage, be in the form of a financial return on the investment, not in the form of consumption.” This rules out most Kickstarter campaigns when considering whether a perk received for contributing to a fundraiser counts as a security. In other words, simply preordering a product does not create a reasonable expectation of profit.
Of course, it might not rule out a fundraiser implying that the perks could be resold to someone else for a higher price. At that point, a simple preorder might transform into an unregistered securities offering.
The “financial return instead of consumption” element became important in the LBRY case, as well, in which tokens could be redeemed for the right to publish digital files on the LBRY platform – innocuous enough. Unfortunately, its backers further promoted LBRY tokens as a way to earn a profit, and those marketing statements turned LBRY tokens into unregistered securities.
No written contract required for Howey
Binance asked the court to consider the idea that the purchase of BNB did not involve an investment contract at all. It says a strict interpretation of the Howey Test would require a “contractual arrangement” in which the buyer “must have contractual rights to share future profits in a common enterprise.”
The SEC rebutted this claim by saying the Howey Test does not require any written contract. It merely requires that there is a “contract, transaction, or scheme” that meets the conditions of the Howey Test.
The SEC also rejected Binance’s argument that transactions on the Binance.com platform didn’t occur in US territory and therefore weren’t subject to US securities laws. It alleges that Binance did sell many securities to US-based investors.
It cited CZ’s ‘Tai Chi Plan,’ first leaked by Forbes’ Michael del Castillo and Jason Brett, which allowed Binance.com to covertly serve US customers using BAM Trading as a distracting proxy. BAM Trading’s second CEO quit because, according to the CEO, “CZ was the CEO of BAM Trading, not me.”
In summary, the SEC has filed its formal rebuttal to Binance’s request to dismiss the SEC’s multi-billion dollar lawsuit. The SEC cites weaknesses in Binance’s pleadings and points out Binance’s attempts to twist the meaning of the Howey Test.