Coinbase to Bankroll Six Investors Claims Against the SEC for Tornado Cash Sanctions
Looking at the instances happening around the crypto space are enough to create skepticism regarding the intentions of the government. Why’s that? Well, the list is long, some are worth mentioning though. Take the Tornado Cash sanction for instance. The Office of Foreign Asset Control (OFAC) sanctioned crypto mixer Tornado Cash, alleging for laundering the crypto assets. According to OFAC, Tornado Cash is responsible for laundering crypto assets worth staggering 7 billion USD. Out of this, a significant amount of 455 million USD belongs to the infamous hacking group of North Korea—the Lazarus Group.
[Smith, A. Coinbase’ Financial Aid to Tornado Cash Supporter Plaintiffs. (Accessed September 20, 2022).].
"On Sept. 8, Coinbase announced it was bankrolling a lawsuit against the United States Treasury Department. The cryptocurrency exchange is funding a lawsuit brought by six people that challenges the sanctions on Tornado Cash. And on Sept. 9, Securities and Exchange Commission (SEC) Chair Gary Gensler announced he was working hard with Congress to create legislation to increase cryptocurrency regulations. But these two stories are not mutually exclusive. The sequence of events proves that governments are purely reactive rather than proactive when it comes to decentralized finance (DeFi)" [Colbert, Z. Coinbase is fighting back as the SEC closes in on Tornado Cash. (Accessed September 20, 2022)].
Brian Armstrong, CEO at Coinbase, in a blog dated September 8, 2022 stated:
Last month, Treasury sanctioned the Tornado Cash software because it was being used by criminals — including North Korean hackers. We have no issue with the Treasury sanctioning bad actors and we take a hard stance against unlawful behavior. But in this case, Treasury went much further and took the unprecedented step of sanctioning an entire technology instead of specific individuals. The problem here is twofold: (1) there are legitimate applications for this type of technology and as a result of these sanctions, many innocent users now have their funds trapped and have lost access to a critical privacy tool, and (2) we believe the Treasury exceeded its authority, given by Congress, by sanctioning a technology.
[Armstrong, B. Defending Privacy in Crypto. (Accessed September 20, 2022)].
Armstrong shared the Treasury's attentiveness toward fighting crime in crypto, and assured that Coinbase has fought against illegal activity from it's beginnings. Nonetheless, Armstrong believes the Treasury's action "harms innocent people and threatens the future of decentralized finance (DeFi) and web3 specifically" [Id].
Armstrong illustrates the above by describing three investors who 'legally' were using Tornado Cash, but now have their funds locked because of the sanctions:
- One person used Tornado Cash to anonymously donate money to Ukraine. Afterwards, his wallet received potentially malicious air drops. But because he anonymized his crypto before donating, he avoided attacks against his personal accounts. He has funds trapped in Tornado Cash.
- Another person is an early crypto adopter with a large online presence and a public ENS name linked to his Twitter profile. He used Tornado Cash to protect his personal security while transacting. Now he also has funds trapped in Tornado Cash.
- A third person operates an Etherum staking business. At one point, a stranger working near where he engages in staking asked how much money he was earning. He started using Tornado Cash to protect his assets and his personal safety.
[Id].
Armstrong provides an illustrative analogy to stress his point, to wit: "Sanctioning open source software is like permanently shutting down a highway because robbers used it to flee a crime scene. It’s not the best way to solve a problem. It ends up punishing people who did nothing wrong and results in people having less privacy and security. We believe law abiding citizens have a right to privacy, especially with some of their most sensitive data: their finances" [Id].
While it is true that the Treasury possesses the authority to sanction specific people and their property, it lacks the power to impose sanctions on open source software. A quick review of the legal basis behind Coinbase's argument in this regard amply displays its merit.
The underlying principles are basic civics:
Federal agencies, like the Treasury Department, ultimately get their authority to act from the people’s representatives in Congress, which enacts legislation defining an agency’s powers. When operating, federal agencies must act within the bounds of that Congressionally defined authority. If an agency’s action exceeds those powers, Congress has also authorized courts to review that action, with the remedy being to set aside the unlawful action. These challenges are critical to preventing executive overreach and ensuring agency action stays within the bounds of what the people’s representatives in Congress allowed.
[Grewal, P. Sanctions Should Target Bad Actors. Not Technology. (Accessed September 20, 2022)].
Paul Grewal, Chief Legal Officer at Coinbase, in a separate blog dared September 8, 2022, explains:
Applying these principles here, Congress passed the International Emergency Economic Powers Act (“IEEPA”), authorizing the President to freeze the assets of, and prohibit transactions with, any person determined to be a threat to the United States, and the President delegated this power to Treasury to issue sanctions. However, this delegated power only authorizes OFAC to target persons or their property. [citing 50 U.S.C. § 1702(a)(1)(B)]. We are supporting the legal challenge to the Tornado Cash action because the Tornado Cash smart contracts are neither person nor property. This means OFAC exceeded its authority from Congress when it recently added these to the SDN List — effectively banning the technology for all U.S. persons. (emphasis added)
[Id].
The heart of Coinbase's argument is two-fold according to Grewal:
First, at the risk of stating the obvious, Tornado Cash open source smart contracts are not persons. They are lines of code, not humans, corporations, or organizations. Tornado Cash’s smart contracts enable a user to deposit tokens from one crypto address and later withdraw those same tokens to a different crypto address, and are executed automatically without human intervention. They are a privacy tool, a technology, that is neither human nor an entity.
Second, and for similar reasons, the Tornado Cash smart contracts are also not property. The ordinary meaning of “property” is something owned, a possession, or a tangible or intangible item that someone has legal title to possess.** The smart contracts are non-proprietary, open source code not controlled by any individual or group. Instead, they are simply programs that run on the Ethereum network according to preset rules that cannot be changed or altered. In the case of the Tornado Cash smart contracts, anyone in the world can send ETH to these contracts, which will then run according to preset instructions that neither the original developers of the code nor those sending or receiving funds can change. When an individual uses these smart contracts, they never turn over control of their assets to another individual or group and assets are not commingled or mixed; they simply use the privacy code to send and then withdraw their assets.
[Id].
And in considering the underlying issues of individual privacy, Grewal states:
The plaintiffs in this lawsuit represent a cross section of crypto users and developers who used Tornado Cash to protect their privacy and security for various legitimate reasons — from wanting to safely donate to Ukraine war relief without risk of Russian retaliation, to concealing salary deposits that would show how much they earn, to preventing malicious actors from targeting their homes to try to steal large quantities of crypto assets held in their wallets. By creating new, private crypto addresses when sending funds to strangers, these plaintiffs could avoid disclosing their personal accounts, which they use to hold their assets and send personal transactions.
[Id].
In relation to privacy, Grewal concludes:
In this way, crypto privacy protocols are not only critical to the development of the crypto ecosystem, they are an important tool to protect individuals against hackers and thieves who may otherwise target owners of crypto addresses that hold significant assets. The sanctions against Tornado Cash have not only blocked this open source technology to U.S. persons, but cryptographers and developers have also been scared away from contributing to other important privacy projects, fearful that their code will be sanctioned in the future.
[Id].
"Finally, sanctioning open-source code has a chilling effect on innovation. Right now, developers are worried that they could be held responsible for something they had nothing to do with, and no ability to control. At a time when we should be encouraging innovation, this kind of fear and uncertainty will do the opposite — making developers wonder if, by pushing the industry forward, they could be putting themselves at risk" [Armstrong, supra].
"The next day, Gensler doubled down on his push for tougher regulation of the DeFi market, claiming crypto companies wouldn’t prosper without it. 'Nothing about the crypto markets is incompatible with the securities laws. Investor protection is just as relevant, regardless of underlying technologies.' Not only does his choice of words such as 'regardless of underlying technologies' betray his lack of understanding of crypto and blockchain technology, but his speech prompted an outcry from the Web3 community, with many claiming government regulation is a wolf in sheep’s clothing" [Colbert, supra].
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But the Tornado Cash sanctions set an alarming benchmark for anyone involved in digital assets. Not only are blockchain technology and cryptography constantly changing — what’s secure now might not be secure in the near future and almost certainly won’t be secure next year — but there are a myriad of legitimate applications for the likes of blockchain tech. DeFi is all about privacy. The clue’s in the name — decentralized finance. Mixers such as Tornado Cash further protect the privacy of its users by mixing users’ deposits and withdrawals in liquidity pools, hiding their addresses and safeguarding their identities. Users want to protect the privacy of their transactions for a range of lawful reasons [...] A person’s finances include some of their most sensitive personal information. And law-abiding citizens have the right to keep this private. But it’s this very privacy that will be eroded by the sort of regulation recently proposed by Gensler, the SEC and other governments around the world.
[Colbert, supra].
"Although not officially related, the timing and similarities between the two stories are telling. Gensler likened regulation to traffic control, saying — “Detroit would not have taken off without some traffic lights and cops on the beat.” Armstrong used a highways and heist analogy, saying, “Sanctioning open-source software is like permanently shutting down a highway because robbers used it to flee a crime scene.” And he’s not wrong. How many talented developers will now be dissuaded from writing game-changing code that could not only innovate industries, but help people across the world? A small number of bad actors should not hinder the progress of a technology with such huge potential to revolutionize sectors beyond even finance" [Id].
Suffice it to say the ramifications flowing from this Coinbase backed litigation is huge. This lawsuit proves to be a turning point in the history of cryptocurrency irrespective of its outcome. Whichever way the case is decided will significantly impact the basis and structure of DeFi, as well as how its users interact with its various platforms.
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