The Polsinelli Blockchain+ team took a break from the usual Bi-Weekly updates for the Thanksgiving holiday, but the Web3 legal developments did not. There was a significant ruling out of the 5th Circuit, which has major implications on the legal treatment of immutable software code and agency actions after Loper Bright generally. There was also an action brought against the SEC by eighteen states regarding the agency’s handling of digital asset matters, a federal district court ruling overturning the SEC’s recently enacted Dealer Rule, and a host of other legal developments that are sure to have ramifications across the industry.
These developments and a few other brief notes are discussed below.
18 States File Lawsuit Against SEC Over Handling of Crypto: November 15, 2024
Background: Eighteen states have filed a lawsuit against the SEC and its Commissioners, accusing them of unconstitutional overreach and unfair persecution of the digital asset industry. The lawsuit was jointly filed in Kentucky federal court by Kentucky, Nebraska, Tennessee, West Virginia, Iowa, Texas, Mississippi, Montana, Arkansas, Ohio, Kansas, Missouri, Indiana, Utah, Louisiana, South Carolina, Oklahoma, and Florida. The lawsuit alleges that the agency’s actions focusing on U.S. crypto companies “defy basic principles of federalism and separation of powers.”
Analysis: The DeFi Education Fund assisted with this effort, which is clear from the pleadings. With Chair Gensler’s impending resignation, to be soon replaced with a more digital asset-friendly head of the SEC, this may just be litigation theater. On the other hand, if any case is going to make it to the Supreme Court on an expedited basis regarding the appropriateness of applying Howey to digital assets, it would be a matter brought by a large number of states against the SEC to be heard by a current group of Supreme Court Justices that have shown their predilections to limiting perceived agency overreach.
Judge Rules Lido DAO Might Be a General Partnership: November 18, 2024
Background: The Court in Samuels v. Lido DAO has rejected motions to dismiss filed by various investors, holding that Lido DAO is adequately alleged to be a general partnership under California law and that the investors are adequately alleged as general partners, which would make them jointly and severally liable for the actions of the DAO. This means the named parties will need to defend themselves in court or risk being held jointly/severally liable if the challenged DAO actions are deemed illegal.
Analysis: The reason for arguments for either corporate wrappers or BORGs is to avoid situations like this where participation in a DAO makes an individual or entity on the hook for everything it does. It seems like judges are easily convinced that the reason for working through DAOs is avoiding liability, as opposed to why many choose the DAO structure to mitigate other risks such as opaque governance and centralized risks. As it stands, it seems like DAOs will need to avoid the U.S. entirely or implement corporate wrappers of some kind to have a target for courts to point a finger to in lawsuits.
Texas Court Strikes Down SEC Dealer Rules: November 21, 2024
Background: A Northern District of Texas district court has ruled in favor of the Blockchain Association’s challenge to the SEC’s promulgated the “Dealer Rule,” which expanded the definition of “Dealer” under the SEC’s interpretation of the Securities Exchange Act. The Court’s ruling states, “The SEC exceeded its statutory authority by enacting such a broad definition of dealer untethered from the text, history, and structure of the Exchange Act.” It also incorporated by reference its analysis in the related case, Nat’l Ass’n of Priv. Fund Managers v. SEC, No. 4:24-cv-00250 (N.D. Tex), where the Court noted, “[under the Dealer Rule], many of the world’s largest, most prominent market participants, including the Federal Reserve, may have been operating unlawfully as unregistered securities ‘dealers’ for 90 years without anyone—including the Commission—having previously noticed.”
Analysis: The Court didn’t even have to reach the arguments regarding whether the rule was arbitrary and capricious or exceeded the SEC’s authority under Loper Bright to overturn the Dealer Rule. This means that SEC rules enacted under Chair Gensler and challenged in court are now 1-and-5 in surviving those legal challenges. That is more rules overturned by courts than the previous 3 SEC Chairs combined. Chair Gensler has announced his planned resignation but elected to stay on as Chair until January 20th, indicating Chair Gensler believes there are additional matters he wants to finalize that may not get done without him there to break a 2-2 tie, so still more to come.
Consumer Financial Protection Bureau Issues Digital Wallet Rule: November 21, 2024
Background: The Consumer Financial Protection Bureau (“CFPB”) finalized its rules to supervise digital funds transfer and payment wallet apps. In announcing the final rule, the CFPB stated it “made several significant changes from its initial proposal. The transaction threshold determining which companies require supervision is now substantially higher, at 50 million annual transactions. Given the evolving market for digital currencies, the CFPB also limited the rule's scope to count only transactions conducted in U.S. dollars.”
Analysis: While Coinbase, the DeFi Education Fund, the Blockchain Association, and others all sent staunch opposition to the proposed rule encompassing self-custody digital asset wallets, most expected the agency formed by Elizabeth Warren would still go through with the rules as written. So the CFPB expressly limiting the rule to wallets for U.S. dollars was a pleasant surprise. Either way, this saves a ton of industry time and effort in not having to file lawsuits to challenge the rule if it had been enacted as previously written.
Fifth Circuit Overturns OFAC Sanctions of Tornado Cash Smart Contracts: November 26, 2024
Background: The Treasury Department’s Office of Foreign Assets Control (“OFAC”) sanctions of the open-source digital asset software protocol known as “Tornado Cash,” which forbid any dealings with the Tornado Cash smart contracts, were overturned by the 5th Circuit. This case was brought by various users of Tornado Cash, claiming the open-source, self-executing software is not sanctionable under the International Emergency Economic Powers Act (as opposed to the rogue persons and entities who abuse that software, who are sanctionable). The Court agreed, holding OFAC only had the power to sanction the “property” of a foreign national or entity, and since Tornado Cash’s immutable smart contracts are not the “property,” they are outside of OFAC's statutory powers to sanction.
Analysis: The Court’s use of diagrams and plain speak to explain how Tornado Cash works was (other than some minor technical misspeaks on pg. 5) surprisingly well done. Hats off to the lawyers that had to effectively teach 76, 65, and 59-year-old judges the fairly complex technical aspects of the mixing platform enough for those judges to recite it back (mostly) accurately and reach the right result. This case may get attention outside of crypto law, as it turned primarily on Loper Bright grounds, which redefined the level of deference (previously known as Chevron deference) given to federal agencies in interpreting statutory text. Now we await the outcome of the various Tornado Cash developer cases. There is also the case pending in the 11th Circuit, which had oral arguments heard recently and is available here.
Briefly Noted:
SEC Chair Gensler Announces Planned Resignation: This was likely going to happen regardless of who won the Presidential election, but Gary Gensler announced he will resign from the SEC effective on inauguration day. With Commissioner Lizárraga also announcing his resignation, that will leave only Commissioners Peirce (pro-crypto), Uyeda (pro-crypto), and Crenshaw (anti-crypto, but on an expired term) left until new Commissioners are appointed by the President and approved by Congress.
Kraken Request for Early Appeal Denied: The judge in SEC v. Payward Ventures (aka Kraken) has denied the exchange’s request for an interlocutory appeal of the dismissal denial ruling. So the case marches on.
Frozen Staking Rewards Still Income: This was released the first week of November, but that was a busy week in crypto legal updates, so our update neglected to include this letter memo where the IRS clarified that their position is staking rewards are taxable the year earned, even if inaccessible due to being frozen on a platform or otherwise locked in a protocol.
Various Articles Published on BSA and Sanction Authorities: The Blockchain Association published this deep dive into the history of the Bank Secrecy Act and argues that the Bank Secrecy Act (“BSA”) is neither fit nor constitutional when applied to digital asset transactions. There was also this recent publication worth reading on the attempted criminalization of the development of open-source cryptocurrency mixing software.
Report on Dollar Dominance Through Stablecoins: Another publication worth reading is this work from the Digital Chamber on how stablecoins are supporting the continuation of U.S. Dollar dominance. Also, be sure to check out this letter from the Digital Chamber calling for the end of the policy forbidding crypto regulators from owning even a de minimis amount of crypto. Forbidding regulators from using the products/services they regulate is simply not sound policy.
Southern District of New York Toning Down Crypto Cases: The co-chief of the SDNY U.S. Attorney’s Office securities and commodities task force said not to expect more crypto cases from the office any time soon with Jay Clayton expected to take over the office.
Conclusion:
In a dynamic and rapidly evolving legal landscape, the past few weeks have highlighted the interplay between innovation, regulation, and judicial oversight within the Web3 ecosystem. From challenges to agency overreach, such as the 18-state lawsuit against the SEC and the Fifth Circuit’s groundbreaking Tornado Cash decision, to rulings that reshape industry practices like the Lido DAO partnership liability and the Dealer Rule’s invalidation, the implications are profound. These developments emphasize the critical need for clarity and balance in how laws and regulations intersect with emerging technologies.
While the legal battles are far from over, the outcomes will undoubtedly shape the future of digital assets, decentralized platforms, and blockchain innovation. As always, staying informed and engaged is key as we navigate this complex yet promising frontier.
