By Kubs Lalchandani, Founding Partner, Lalchandani Simon PL
On June 28, 2024, late Friday evening, buried within a 90-page opinion published amid the post-presidential debate fallout and the Trump immunity decision news cycle, a D.C. District Court Judge, appointed by Obama, delivered a critical blow to the SEC's expansive theory on crypto regulation. The judge rejected the notion that digital assets remain securities perpetually, stating:
"Insisting that an asset that was the subject of an alleged investment contract is itself a 'security' as it moves forward in commerce... marks a departure from the Howey framework that leaves the Court, the industry, and future buyers and sellers with no clear differentiating principle between tokens in the marketplace that are securities and tokens that aren’t. It is not a principle the Court feels comfortable endorsing or applying."
Despite the significant implications, this ruling has gone largely unnoticed in the media, primarily because most of the SEC's claims against Binance will continue. However, the court's complete rejection of the SEC's theory concerning secondary market sales of digital assets is a major setback for the regulatory body. The remaining claims are now focused on Binance's alternative services, such as staking and vault products. Interestingly, because the SEC is able to proceed on most of its claims based on non-secondary market sales offerings, the headlines for the most part have portrayed this as an SEC win. In fact, it is one of their most devastating losses.
This rejection of the SEC's embodiment theory is crucial for several reasons. Firstly, it aligns with Judge Torres's understanding of digital assets, which largely cuts against the SEC's ability to dismiss the Ripple Labs case as an outlier. Secondly, it highlights the SEC's inconsistency in its approach, emphasizing to the public, the Biden administration, and other judges the need for clear regulatory rules rather than broad, ambiguous claims.
Background: The SEC's case against Binance, CZ, and related entities involved several alleged securities law violations. The SEC argued that secondary sales of digital assets constituted securities transactions, based on the initial sales meeting the Howey test criteria. Judge Berman Jackson disagreed, particularly with the notion that secondary sales of BNB (Binance's corporate token) and other listed "crypto asset securities" could be considered securities.
Judge Berman Jackson adopted an analytical framework similar to Judge Torres's decision in Ripple Labs, recognizing the distinction between initial and secondary market sales:
"Whether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and the economic reality of that specific contract, transaction, or scheme."
In applying this test, Judge Berman Jackson criticized the SEC's blanket assumption that secondary market sales of BNB on Binance's platform were securities. Additionally, she dismissed the SEC's references to other crypto assets on Binance, noting that the issuers were not parties to the action and had not been given an opportunity to respond to the SEC's claims.
This ruling suggests a need for the SEC to rethink its approach to regulating crypto exchanges. The importance of this opinion to the crypto industry cannot be overstated:
1. It is the first case to expressly reject the SEC’s “embodiment” theory on digital assets.
2. As a D.C. Circuit Court ruling, it could lead to a potential conflict with the Second Circuit, where the Coinbase action was filed, and whose judge largely agreed with the SEC's theory.
3. It underscores the growing judicial criticism of the SEC's regulation-by-enforcement strategy, which has created a lack of clarity and consistency in the crypto regulatory landscape.