Q9 Weekly: This is Howey Do It
8 June 2023
This is Howey Do It
- Binance and Coinbase formally charged by SEC
- CZ accused of fraud, securities violations, and comingling client assets
- Did they break the Howey Test?
This week, the SEC brought charges against crypto exchanges Binance and Coinbase in consecutive days, alleging that both operated unlicensed securities exchanges in the United States, amongst other charges.
The lawsuits differ in many ways. Though the allegations against Coinbase are serious, the complaint against Binance is much more damning: It accuses its CEO Changpeng Zhao of operating a “web of deception”, of committing fraud, and is significantly longer with heavier allegations.
Bitcoin-maxi’s seem to have shrugged it off with BTC (-3.2%) quickly bouncing back after tumbling to a three-month low of less than $25,500 on Tuesday following news. The Binance Smart Chain token BNB fell 16%. Cardano’s ADA, Polygon’s MATIC and Solana’s SOL, all top 10 tokens by market cap that were noted in the SEC filing as potential securities, recently took a dive between 10% and 14%.
BNB Falls Following Binance Charges
Source: TradingView
SEC vs CZ
The SEC filed 13 charges against Binance and its founder, Changpeng Zhao, alleging both comingled billions of dollars’ worth of user funds and sent them to a European company controlled by Zhao.
The SEC has also asked for an emergency order to freeze Binance.US assets anywhere in the world. If granted, Binance would have five days to prove only Binance.US has access to customer funds, and 30 days to transfer those funds to wallets only the US-based unit of the global exchange can access.
The regulators accompanying press release chose this as its topline: “Charges include operating unregistered exchanges, broker-dealers, and clearing agencies; misrepresenting trading controls and oversight on the Binance.US platform; and the unregistered offer and sale of securities.” Of all of the allegations levied, the most damaging one is potentially the allegation of the “commingling” of customer funds. “Defendants were free to and did transfer investors’ crypto and fiat assets as Defendants pleased, at times commingling and diverting them,” according to the SEC’s filing.
Two successive Binance.US CEOs expressed deep concern over Zhao’s level of control, according to the SEC. Both testified before federal regulators: Neither were named, but its first and second chief executives were Catherine Coley and Brian Brooks.
One senior executive also allegedly told a compliance officer that the company was operating as a ”[f — -ing] unlicensed securities exchange in the USA bro.”
The SEC alleges Zhao ordered the creation of an evasion plan for high-net-worth customers, using a VPN service to hide their US location and submitting compliance documents to obscure their country of origin.
The regulator also alleges that Binance and Zhao used market-making companies that they controlled to inflate trading prices and profit off of their customers. They allegedly engaged in “wash trading,” trading with themselves to artificially prop up the price of crypto assets.
Ownership Structure Under Binance CEO Zhao
Source: SEC Filing
Binance is vehemently pushing back on allegations, stating that “any allegations that user assets on the Binance.US platform have ever been at risk are simply wrong,” and “all user assets on Binance and Binance affiliate platforms including Binance.US. are safe and secure”
Often, when the SEC acts, the Department of Justice (DOJ) does too. So far only the SEC has gone after Binance and CZ, but there is speculation DOJ could be next. In the face of that, Binance have let it be known that Richard Teng is a rising star at the exchange. One wonders if that’s bait for a potential settlement: CZ steps down and Teng takes over?
Strong-arming Armstrong
Brian Armstrong’s Coinbase, the largest crypto exchange in the US by volume, was also charged by the securities regulator, claiming that the company broke the law by not registering as a broker.
Adding to Coinbase’s legal troubles, securities regulators in 10 states, including Alabama, California, Illinois and New Jersey, filed their own actions on Tuesday seeking to stop the company from selling unregistered securities to investors in their states.
“Coinbase has elevated its interest in increasing its profits over investors’ interests, and over compliance with the law and the regulatory framework that governs the securities markets and was created to protect investors and the U.S. capital markets,” the filing said.
Coinbase May Account for Just 6.5% of Global Volume, but US Market Share is a Whopping 53%
Source: Kaiko
Unlike Binance, Coinbase does not issue its own crypto tokens, and the company has argued that its status as a publicly listed company ensured that it followed strict rules about its operations.
Also unlike the complaint against Binance, the lawsuit against Coinbase notably did not include an allegation of fraud, charge CEO Brian Armstrong directly, or request for a preliminary injunction against the company.
Testing Times
The suits against Binance and Coinbase both touched on a crucial issue that many in the crypto industry have said Congress must address: whether digital asset products are securities or something totally different.
The SEC has said the test to determine whether a crypto product should be treated like a security is derived from a 1946 Supreme Court case that led to what is known as the Howey test. Gary Gensler has often said that this standard is clear and that no new laws are needed to determine whether a digital asset is a security. The industry, however, has begged to differ.
According to the 101-page complaint, “Coinbase has for years made available for trading crypto assets that are investment contracts under the Howey test and well-established principles of the federal securities laws.”
Tokens Targeted by the SEC as Securities in Binance and Coinbase Lawsuits
Source: Blockworks
The implications of the Howey test for cryptocurrency are significant. The test determines what qualifies as an “investment contract” and would therefore be subject to securities laws. An investment contract exists if there is:
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others
Yet this is a hopelessly broad set of criteria, and if it applies to crypto it could also feasibly apply to trading cards or sports betting, things everyone can agree the SEC should not fiddle with. So, ultimately, the implications of the Howey test for crypto will depend on how regulators choose to apply the test in practice and how crypto companies choose to structure their offerings to comply with federal securities law. The outcome of the legal cases against Coinbase and Binance will have far reaching consequences for the industry if some or all of the named tokens are deemed to be securities.
Matt Levine at Bloomberg wrote a great long-read on the issue this week: When Is a Token Not a Security?
The worry underlying the lawsuits is not, of course, just that cryptocurrencies are securities and that therefore Coinbase and Binance should have registered with the SEC. The worry is that they operate not just as exchanges in this market, but as brokers, clearers, custodians and in some cases investment funds too, and that having all those functions performed by a single entity sets up terrible conflicts of interest.
The barrage of litigation appear to be an attack against the structure of digital-asset markets, with smaller companies likely to become the next targets if the agency prevails against the two industry leaders… and yet again the vast majority of issues within crypto continue to surround the actors and not the asset itself.
In the News…
- JPMorgan uses blockchain for 24/7 dollar transfers with Indian banks
- DRW’s Cumberland highlights need for non-USD stablecoins
- Circle to launch USDC natively on Arbitrum
- Avalanche hits 1mn monthly active users for the first time
- Tether invests in El Salvador’s $1bn renewable energy project
- Atomic wallet users hacked for $35mn worth of various tokens
- Crypto infrastructure firm Anoma Foundation raises $25mn
- Transak secures $20mn to solve Web3 onboarding end-to-end
- Meanwhile raises $19mn for crypto-denominated life insurance, led by Sam Altman
- Do Kwon out on bail under house arrest after successful appeal
- Apple releases new Vision Pro mixed reality headset
