Stablecoins Unlikely to Be Subject to the SEC’s Jurisdiction

The recent decision in Securities and Exchange Commission v. Binance Holdings Limited et al (Binance)¹ has cast further doubt on the Securities and Exchange Commission’s (SEC’s) pursuit of jurisdiction over stablecoins. On June 28, 2024, the US District Court for the District of Columbia granted the defendants’ motion to dismiss the SEC’s claim that Binance’s stablecoin BUSD was a security, consistent with other court decisions relating to stablecoins.

Of particular interest to the stablecoin industry is the court’s affirmation that stablecoins fully backed with reserves and redeemable on a 1:1 basis with a fiat currency such as the US dollar or the euro (such as Binance’s BUSD or Circle’s USDC) are not in and of themselves “investment contracts” and are thus not subject to the regulatory authority of the SEC.

Furthermore, shortly after this decision, the SEC indicated that it would not recommend an enforcement action against Paxos for its involvement in the issuance of BUSD. These developments are further evidence of what the stablecoin industry has been asserting for years: Sales of fully reserved 1:1 redeemable stablecoins are not investment contracts.

Background

The SEC has brought suit against the digital-asset-trading platform Binance Holdings Ltd.; its founder, Changpeng Zhao; and two related US entities (hereafter, Binance), asserting that Binance (1) offered and sold crypto assets and related programs, including its stablecoin BUSD,²  without a registration statement; (2) operated crypto-currency trading platforms without registering as an exchange, as a broker-dealer or broker, or as a clearing agency; and (3) made false statements to investors and engaged in acts and practices that operated as fraud upon purchasers. The defendants filed a motion to dismiss these claims and asserted various issues relating to the extraterritorial application of the SEC’s jurisdiction.

The court rejected many of the defendants’ arguments but granted the motion to dismiss in part, including vis-à-vis Binance’s stablecoin token BUSD.

The Court Rejected the SEC’s Embodiment Theory

The SEC alleged that Binance’s offering and selling of BUSD stablecoin tokens constituted an investment contract and therefore was a security under the Supreme Court’s test in SEC v. W.J. Howey Co. The three components of the Howey test require: (1) an expectation of profits arising from (2) a common enterprise that (3) depends upon the efforts of others.³ The court disagreed with the SEC and granted Binance’s motion to dismiss vis-à-vis BUSD.

In particular, the court rejected the SEC’s suggestion that BUSD was the embodiment of the alleged investment contract rather than the potential subject of such a contract, endorsing instead a more holistic and contextual analysis:

In the Court’s view, then, the SEC’s suggestion that the token is “the embodiment of the investment contract”… as opposed to the subject of the investment contract, muddied the issues before the Court, ignored the Supreme Court’s directive that the analysis is supposed to be based on the entire set of understandings and expectations surrounding the offering, and unnecessarily invited the defendants’ argument that a decision in the government’s favor here would somehow encroach on the jurisdiction of the Commodities Futures Trading Commission. … Therefore, the Court will endorse and follow the approach taken by the thoughtful judges who boldly wrestled with crypto assets before this case was filed, and it will assess the offerings identified in the complaint individually, resisting the government’s implication that this ruling could go so far as to answer the definitional question that officials in the other branches of government appear to have been assiduously avoiding. In short, no one should read this case as deciding that crypto assets themselves are or are not “securities”; that is not the question presented.⁴  [Citations omitted.]

While the court acknowledged the difficulty in categorizing intangible digital assets, noting that they “do not fit neatly into the rubric set forth in the mere seven pages that comprise the Howey opinion,”⁵ the court also expressed its frustration with the SEC’s inability to articulate how to distinguish between crypto assets from crypto asset securities.

Although the SEC agreed with the court that a “crypto asset … is simply a line of code” and a determination of whether the asset was a security would turn on “the economic realities and the totality of circumstances of how they’re offered and sold”⁶ as Howey requires, the court noted that the “SEC seemed reluctant at that time to clarify fundamental aspects of its position.” ⁷During the initial proceedings on the SEC’s request for a temporary restraining order, the court was keen to press the SEC on the nature of crypto assets that were not securities:

THE COURT: But you have said all over the complaint crypto assets — and you differentiate that specifically from crypto asset securities, and you make it clear that one category is larger than the other category. … I’m asking you, the ones that you are not putting in the securities category, what are they? Are they commodities?

[SEC]: We are not — thank you, Your Honor. We are not taking a position at this time …⁸ 

The court also noted that “the SEC seemed to [be] speaking out of both sides of its mouth” on the issue of whether “once the assets were sold as securities, they retained that character forever,” sometimes explicitly disavowing such a conclusion while leaving “the distinct impression that that was exactly what [the SEC] meant” at other times.⁹

1:1 Stablecoins Are Not Investment Contracts

The court concluded that the SEC failed to plausibly allege that Binance offered and sold BUSD as an investment contract.¹⁰ In particular, the court pointed to the absence of any evidence that purchasers were “informed that the proceeds from BUSD sales were to be deployed, through the issuers’ managerial and entrepreneurial efforts, to generate a return for their benefit.”¹¹

As the court took pains to point out, the issue was not whether “crypto assets themselves are or are not ‘securities’” but rather whether, as the SEC alleged, BUSD “was offered and sold as a package, as an opportunity for purchasers to participate in [Binance’s] other profit-making programs.”¹² The court found that there was no such expectation of participation, noting that the SEC failed to lead sufficient evidence to prove that the individual purchasers of BUSD tokens — as opposed to Binance itself — “reasonably expected to share in the companies’ profits in the form of a return on their investment.”¹³ Because there was no expectation of profit, the offering and sale of BUSD stablecoin tokens was not an investment contract and therefore not a security requiring registration with the SEC.

Not Every Profit-Making Opportunity Is an Investment Contract

In likewise dismissing the SEC’s action in respect to another Binance product, Simple Earn, the court clarified that even certain profit-making schemes offered through crypto assets will not qualify as investment contracts if the offeror disclaims any connection between the input and the return. As the court noted:

Not every “profit-making opportunity” is an investment contract, and the allegations concerning Simple Earn do not describe a scheme or transaction in which investors were urged to put their money in Binance’s hands so that they could share in the return that Binance would generate through its managerial or entrepreneurial efforts. The holders of crypto assets simply agreed to loan them to the company for a specified period of time at a specified rate of interest, and the complaint lacks any allegation that they were led to believe that Binance’s efforts would generate the return or make the assets more valuable at the end of the day. Binance could pool the assets or not, and it could deploy them for any purpose, without any connection between the use of the funds and the rewards paid to “investors.” Moreover, the interest rate paid would be set at Binance’s discretion, at a rate that would take market conditions and competitors’ offerings into consideration, and the company explicitly disavowed any relationship between the interest rate to be paid and the company’s profitability.¹⁴

Court Identifies Other Factors in Determining Investment Contracts

In discussing another Binance token, BNB, which was first issued pursuant to an initial coin offering and is not a stablecoin, the court identified several factors that might or might not support the finding of an investment contract. While each of the following factors might support or reduce the likelihood of the existence of an investment contract in difference circumstances, they support the position that fully backed 1:1 stablecoins are not investment contracts:

• Circumstances of sale and purchaser’s reasonable expectations: As the court noted, “it does matter how the asset was sold and what a purchaser in the marketplace would have reasonably understood it to be. … the complaint contains very little concerning how BNB was actually promoted and sold after the ICO.” These factors are contextual and might make a digital asset either more or less likely to be deemed an investment contract, depending on the totality of the circumstances — which is entirely consistent with the Howey analysis.¹⁵
• Issuer’s actions in deliberately increasing demand or reducing supply: If an issuer destroys or “burns” quantities of the pooled digital asset, it might boost the “efforts of others” component of the Howey analysis and make it more likely that the asset is being offered as an investment contract.¹⁶
• Consumptive intent and presence of extended lockup period: The court noted that a lengthy “lockup” period in which the asset cannot be used would make it more likely that the asset is being offered as investment contract. The court noted other courts’ recent holdings that locking up an asset for an extended period of time is not consistent with a purchaser for the purpose of consumption (“… a rational economic actor would not agree to freeze millions of dollars for up to 18 months …”), although it noted that the opposite is not necessarily true — i.e., the absence of a lockup period should not be taken as proof of consumptive intent.¹⁷
• Other uses of the token, including for payment of platform fees: The court pointed out that other potential uses of the token, such as redemption of tokens for discounted fees on the platform, may make it less likely that the tokens are being offered as investment contracts. As the court noted:

It is also significant that one key selling point of the BNB coin detailed in the Whitepaper was that purchasers could use BNB to pay for any fees on the platform, including exchange fees, withdrawals fees, listing fees, and any other fees, and that when they used BNB to pay those fees, they would receive significant discounts … the allegation that Binance is marketing BNB — successfully — by emphasizing the ways it can be used raises questions about the strength of the showing supporting the existence of the “expected profits” element over time.¹⁸

In applying these factors to stablecoins, a court would likely find that (1) stablecoins are not purchased with an expectation that the stablecoin will generate profits for the purchaser; (2) stablecoins are issued and redeemed by buyers, as needed, with no limits imposed by the issuer; (3) stablecoins are used to facilitate transactions, not to simply hold and sell, and there are no lockup periods on stablecoins; and (4) stablecoins are often used to pay for goods and services, including for the authors’ services.

This Decision Is Consistent With Other Federal Court’s Holding That Fully Reserved 1:1 Stablecoins Are Not Investment Contracts and the SEC’s Decision to Not Pursue Paxos

The court’s decision in Binance aligns perfectly with the distinction drawn by the Southern District of New York in two recent opinions in Securities and Exchange Commission v. Terraform Labs Pte. Ltd. And Do Heyong Kwon (Terraform). Terraform had created a stablecoin, UST, the value of which was purportedly permanently and algorithmically pegged 1:1 to the US dollar.

First, the court in Terraform previewed its thinking on stablecoins in its July 31, 2023, opinion denying the Terraform defendants’ motion to dismiss the SEC’s action, finding that:

… where a stablecoin is designed exclusively to maintain a one-to-one peg with another asset, there is no reasonable basis for expecting that the tokens — if used as stable stores of value or mirrored shares traded on public stock exchanges — would generate profits through a common enterprise.¹⁹

Second — and in line with the court’s reasoning in Binance above — the court in Terraform found that the offering and sale of Terraform’s UST token (unlike Binance’s BUSD token) was in fact the subject of an investment contract, relying chiefly on the Anchor Protocol on Terraform’s website, which stated that “[d]eposited stablecoins are pooled and lent out to borrowers, with accrued interest pro-rata distributed to all depositors.”²⁰ [Emphasis added.] Taken together, these decisions suggest an emerging consensus among federal courts that stablecoins will not be deemed the subject of investment contracts if they do not provide an expectation of pro rata profits.

The Binance and Terraform rulings may have played a role in the SEC’s decision to close its investigation of Paxos regarding BUSD. Paxos, which launched BUSD in partnership with Binance in September 2019, had been operating under the cloud of a potential enforcement action since the SEC served it with a Wells notice in February 2023. However, on July 9, 2024, in the wake of the Binance holding, Paxos was advised by the acting chief of the SEC’s Crypto Asset and Cyber Unit that he would no longer recommend an enforcement action against Paxos regarding BUSD.

 

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^[1] Securities and Exchange Commission v. Binance Holdings Limited et al, (District of Columbia District 1:23-cv01599) (Binance).
^[2] For ease of reference, BUSD is a Binance-branded US dollar-denominated crypto asset on the Ethereum blockchain — in other words, it is a “stablecoin” that is purportedly backed with cash (and cash equivalent) reserves and redeemable on a 1:1 basis for US dollars.
^[3] Binance p. 13.
^[4] Binance p. 20.
^[5] Binance p. 21.
^[6] Binance p. 40-41.
^[7] Binance p. 40, footnote 14.
^[8] Binance p. 40, footnote 14.
^[9] Binance p. 42, footnote 15.
^[10] Binance p. 47.
^[11] Binance p. 48.
^[12] Binance p. 20 and p. 51, footnote 21.
^[13] Binance p. 48.
^[14] Binance p. 52-53.
^[15] Binance p. 36
^[16] Binance p. 30.
^[17] Binance p. 30-31.
^[18] Binance p. 31 and p. 36.
^[19] Securities and Exchange Commission v. Terraform Labs Pte. Ltd. And Do Heyong Kwon, 23-cv-1346 (Southern District of New York, Jul. 31, 2023) (“Terraform Motion to Dismiss”), p. 33.
^[20] Securities and Exchange Commission v. Terraform Labs Pte. Ltd. And Do Heyong Kwon, 23-cv-1346 (S.D.N.Y Dec. 28, 2023) (Terraform Summary Judgment), p. 7.

 

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