Source: Protos

Compiled by: GaryMa, Wu Blockchain

On June 5, 2023, the U.S. Securities and Exchange Commission (SEC) filed a lawsuit against Binance and its CEO Changpeng Zhao (CZ) for billions of dollars in fines. This week, the SEC responded to Binance's formal motion to dismiss the lawsuit, reiterating and clarifying its claims.

The SEC's lawsuit accuses Binance of illegally financing itself by selling two tokens, BNB and BUSD, to many U.S. investors. This financing, along with the millions of dollars earned by selling other unregistered securities, resulted in at least $11.6 billion in revenue.

In explaining its reasoning, the SEC focused on the Howey test, which U.S. courts typically use to determine whether someone is illegally selling crypto assets. The Howey test refers to a 1946 U.S. Supreme Court ruling in SEC v. W.J. Howey Co., in which the Supreme Court defined an investment contract as a transaction that meets the following four conditions:

• Investment of money
• Common enterprise
• Expectation of profits
• Profits derived from the efforts of others

Some of the SEC's arguments focus on the court's flexible interpretation of the Howey test in previous cases involving suspected securities. For example, it cited three court rulings that "money" can take various forms, not just legal tender like the U.S. dollar. For instance, goods and services for which someone is willing to pay a monetary value can be exchanged in kind for securities.

Binance stated that despite the lawsuit, it did not list/list securities

The SEC used decades of legal precedent to counter Binance's claim that it did not list securities. It clarified that an investment contract is a purposive catch-all term, encompassing a wide range of tools used by initiators of fundraising.

In fact, the SEC summarized decades of court rulings supporting its view: "Congress broadly defined 'security' to reflect a flexible rather than static principle, one capable of adaptation to countless and variable schemes devised by those who seek the use of other people's money in the hope of profit. The courts have found a variety of novel or unique investment instruments to be investment contracts, including those involving orange groves, animal breeding programs, bovine embryos, mobile telephones, businesses existing solely on the internet, and crypto assets."

The SEC claimed that the price of the BNB token may fluctuate based on Binance's efforts and luck, making it a "vertical common enterprise." It rejected Binance's claim that the long-term performance of BNB is ultimately unrelated to Binance's efforts.

Binance's lawsuit involves vertical commonality

'Vertical commonality' exists when the fate of token holders is aligned with the fate of token leaders. The 'vertical enterprise' of BNB includes token holders maintaining a sufficiently high price so that Binance executives can fund the development of the digital asset ecosystem, attract new users through Binance.com, promote BNB through Binance's platform and marketing channels, and develop funds for BNB's blockchain.

In this way, all efforts of Binance executives are fully aligned with the financial interests of retail BNB token holders. In fact, Binance executives themselves are the largest BNB token holders. Therefore, all BNB token holders share vertical commonality with Binance executives.

The SEC cited the BitConnect case, in which the court ruled that the "platform itself is a common enterprise." In BitConnect, members had vertical commonality; the value of the BitConnect token (BCC) depended on the collaborative efforts of BCC token holders and promoters.

Pre-orders on Kickstarter are not securities

To clarify that investment contracts do not encompass all financial offerings, the SEC cited a case where profits "must be derived from the efforts of others and not from the consumption of the purchaser." This excludes most Kickstarter activities, considering whether benefits received for contributing to fundraising count as securities. In other words, simply pre-ordering a product would not create an expectation of profit.

Of course, this may not exclude a fundraising implying that benefits can be resold at a higher price to others. At that point, a simple pre-order could turn into an unregistered securities offering.

The element of "profits derived from the efforts of others and not from the consumption" also became important in the LBRY case, where tokens could be used to obtain rights to digitally published files on the LBRY platform, which seemed harmless. Unfortunately, further marketing claims by its supporters turned LBRY tokens into unregistered securities by promoting them as a way to profit.

Howey test does not require a written contract

Binance argued that the purchase of BNB fundamentally does not involve any investment contract. It stated that a strict interpretation of the Howey test would require a "contractual arrangement," i.e., the buyer "must have a contractual right to share in the profits of the common enterprise."

The SEC countered this argument, stating that the Howey test does not require any written contract. It only requires the existence of "contracts, transactions, or schemes" that meet the conditions of the Howey test.

The SEC also rejected Binance's argument that the trading on the Binance.com platform did not occur within U.S. territory and therefore is not subject to U.S. securities laws. It claimed that Binance sold many securities to numerous U.S. investors.

It cited Changpeng Zhao's "Tai Chi Plan," which was first exposed by Forbes' Michael del Castillo and Jason Brett. This plan allowed Binance.com to secretly serve U.S. customers by using BAM Trading as a deceptive agent. The second CEO of BAM Trading resigned, stating, "CZ is the CEO of BAM Trading, not me."

In conclusion, the SEC has provided a formal response to Binance's request to dismiss its multibillion-dollar lawsuit. The SEC pointed out the weaknesses in Binance's defense and highlighted Binance's efforts to distort the meaning of the Howey test.

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