Consensys sues SEC over plans to label ETH an unregistered security

Ethereum-based blockchain software outfit Consensys has sued America’s securities regulator over its plan to declare the ETH token an unregistered security.

On April 25, Consensys Software Inc. filed a complaint in the U.S. District Court for the Northern District of Texas against the Securities and Exchange Commission (SEC), its chairman Gary Gensler and its other four commissioners. The complaint seeks protection from the SEC’s “regulatory overreach” and “the ambition of the administrative state to control innovative technologies.”

The complaint deals with several topics, but let’s first tackle its claim that the SEC is seeking “to regulate ETH as a security.” Consensys wants the court to compel the SEC to declare that ETH isn’t a security and that Consensys’s sales of ETH aren’t sales of securities, and thus, the SEC would be exceeding its authority by taking any action against Consensys.

In March, news spread that the SEC had served subpoenas on several entities regarding their dealings with the Ethereum Foundation. The substance of these subpoenas hasn’t been confirmed, but one recipient claimed the SEC was probing Ethereum’s September 2022 transition from a consensus mechanism based on proof-of-work (PoW) to one based on proof-of-stake (PoS).

The SEC reportedly believes ETH is an unregistered security according to the Howey test for identifying securities, but also because of Ethereum’s controversial pre-launch distribution of massive amounts of tokens to insiders, including Consensys founder Joseph Lubin.

The SEC also reportedly believes that ETH is now even more of an unregistered security than it was before the PoS transition. Ethereum insiders already held the bulk of issued ETH, but since PoS-based staking requires putting up 32 ETH–worth over $100,000 today—it’s ETH whales who are conducting the bulk of transaction verifications and receiving the ETH rewards (further concentrating power in the hands of the few in an unvirtuous doom-loop).

While Ethereum whales and those with vested interests in other protocols will go to their graves insisting that their tokens aren’t securities, the fact is they’re all securities. Pre-launch distributions of tokens to insiders, centralized control of the protocol, dependence on a core group of kingpins for ensuring that ‘number go up’ … all fingerprints on the murder weapon left at the crime scene.

The exception to this rule is BSV, which resides on the only enterprise blockchain that can trace its history back to the Bitcoin genesis block. BSV boasts a locked protocol, ensuring that it retains the original characteristics described in Satoshi Nakamoto’s 2008 Bitcoin white paper.

Last year, the Buffone Law Group issued guidance that BSV was likely to be the only token that didn’t qualify as a security under U.S. law. In other words, BSV will end up being the only one standing when regulators—not just in the U.S., but worldwide—finally shut down the speculative circus that has blinded the general public to the societal benefits that a truly scalable enterprise blockchain like BSV can offer.

Bought and paid for

Getting back to the Consensys complaint, much of its ‘ETH is not a security’ argument is based on a June 2018 speech by William Hinman, Gensler’s predecessor as SEC chairman. Hinman’s speech proffered the untested theory of “whether a digital asset offered as a security can, over time, become something other than a security.”

Shrugging off Ethereum’s controversial pre-launch ETH distribution, Hinman declared that the “present state” of the Ethereum network meant that “current offers and sales of Ether are not securities transactions.” It later came out that Lubin and other Ethereum bigwigs had lobbied Hinman hard to make that public utterance.

Furthermore, Simpson Thacher, the law firm that Hinman left to join the SEC and swiftly rejoined after he left the SEC, was a member of the Ethereum Enterprise Alliance, a group devoted to promoting all things Ethereum. Hinman earned millions in profit-sharing from Simpson Thacher during his SEC tenure, despite SEC watchdogs telling him in no uncertain terms that he was in “full financial conflict” with his old firm.

At the time of Hinman’s speech, there was plenty of internal debate at the SEC as to whether or not his words reflected official policy. Regardless, the process by which Hinman formed his views is proof that you don’t want to be around when the sausage is made.

The Consensys complaint claims that ETH is “a digital asset the SEC, the [Commodity Futures Trading Commission], and the public at large had long understood fell outside the SEC’s grasp.” This view of Hinman’s opinion as sacrosanct and impervious to question ignores centuries of jurisprudence, which, from time to time, decides to do a 180° from decisions like Dred Scott or Roe v Wade.

Federal regulators are equally prone to rethinking decisions made by their predecessors, such as the Federal Communication Commission’s (FCC) recent reversal of the Trump-era decision to kill off net neutrality rules.

In other words, Lubin’s argument that the SEC doing an about-face on ETH’s security status would be unfair—based on how much time, effort and resources Ethereum fans have invested to date—is more of a prayer than an inviolable rule inscribed on a stone tablet by the finger of God.

DeFi reckoning looms

The complaint reveals that Consensys is effectively adopting a ‘best defense is a good offense’ strategy by filing before the SEC strikes first. Consensys says it received a Wells notice from the SEC on April 10, indicating the regulator’s plans to “bring an enforcement action against Consensys for violating the federal securities laws through its MetaMask Swaps and MetaMask Staking products.”

A phone call with the SEC later that same day revealed that the SEC believes Consensys is acting as an unregistered broker-dealer via MetaMask Swaps, while the Staking program represents the offer and sale of unregistered securities.

The complaint states that both Swaps and Staking “are software that help users interact directly with third-party protocols on the Ethereum blockchain. Nothing more, nothing less. The notion that they could cause Consensys to operate as either a broker or seller of securities is contrary to precedent and common sense.”

Swaps allows users to trade Ethereum-based tokens from within their mobile or desktop browser. In March, the SEC announced a settlement with Erik Voorhees’ digital asset exchange ShapeShift, which similarly acted as a middleman for its users’ trading of unregistered securities (much like an online poker site hosts players who bet against each other, not the house).

And just like a poker site taking a rake of the pot, Consensys charges users fees for using its staking and swapping services. Conveniently, this fact goes unmentioned in its 34-page complaint.

Consensys might believe its software has some kind of legal identity of its own, thereby expunging its developers/owners/operators from responsibility. The fools behind the Samourai Wallet coin mixing service thought that too, and look where they are.

April 10 was also the day that Uniswap Labs went public with news of receiving its own Wells notice, which was reportedly based on the SEC’s interest in Uniswap’s decentralized exchange and its native token UNI. Taken together, the Uniswap/Consensys notices indicate the SEC is now training a more critical eye on the decentralized finance (DeFi) sector’s historic skirting of U.S. securities laws. 

The SEC has previously issued Wells notices to other companies offering staking programs, including the U.S.-based exchanges Coinbase (NASDAQ: COIN) and Kraken. The latter closed its U.S.-facing staking program a year ago, paying a $30 million penalty in the process. Both companies remain locked in litigation with the SEC for selling unregistered securities. Earlier this month, a federal judge ruled that the SEC had sufficiently proven that Coinbase’s staking service involved peddling unregistered securities to allow the SEC’s complaint to proceed.

‘True’ North

The law appears solidly on the SEC’s side but Consensys appears to be stacking the legal deck in its favor. The company recently relocated its headquarters from New York to Fort Worth, allowing it to file its complaint in the Northern District of Texas. In an April 26 appearance on the Unchained podcast, Consensys legal counsel Laura Brookover said the move would allow Consensys “to call on the courts to please help us because what the SEC is doing is unlawful.”

The Northern District has repeatedly demonstrated its eagerness to push back on anything the Biden administration does or seeks to do. Its rulings have been loudly criticized by other conservative judges, including those on the U.S. Supreme Court, as being based more on politics than legal reasoning.

As a result, Consensys stands a good chance of securing an early ruling in its favor. The SEC will appeal, but the Fifth Circuit Court of Appeals is similarly devoted more to MAGA-style politics rather than the rule of law. The SEC’s only hope after that will be the U.S. Supreme Court, which has smacked down some of the Fifth Circuit’s more egregious rulings in recent months.

The SEC is anything but perfect, and its zeal to bring ‘crypto’ scofflaws to heel hasn’t always gone according to plan. In March, a federal judge imposed sanctions against the SEC for “bad faith conduct in obtaining, maintaining, and defending” its temporary restraining order against the DEBT Box crypto firm. On April 21, the two SEC lawyers responsible for the gaffes resigned.

Ethereum’s many and varied transgressions will require no such embellishment. Speculation is out. Utility is in. Don’t find yourself without a seat when the music stops.

Watch: How Teranode enables unbounded scaling