The perplexing debate over whether or not a digital asset qualifies as a “security” or a “commodity” continues to frustrate U.S. regulators and industry participants as we’re not getting much closer to understanding the criteria that define them. really distinguished.
But now things have only gotten interesting with regard to the role that developers and smart contracts play in a securities class action lawsuit.
In a “first impression case,” New York District Judge Katherine P. Failla considered whether the developers and investors in the Uniswap Protocol crypto exchange platform were subject to various provisions of our current federal securities laws.
The class action lawsuit, filed on September 27, 2022, revolved around Uniswap’s alleged involvement in the creation and distribution of fraudulent tokens, which allegedly caused financial loss to investors.
Specifically, the complaint named Universal Navigation Inc., d/b/a Uniswap Labs, its CEO Hayden Adams, and the Uniswap Foundation, alleging two primary federal securities claims against Uniswap:
- The termination of Plaintiff’s purportedly “illegitimate contracts” with Uniswap pursuant to section 29(b) of the Securities Exchange Act of 1934; And
- Uniswap’s alleged violation of Section 12(a)(1) of the Securities Act of 1933.
Both plaintiffs’ claims stem from reported losses arising from scams and other misconduct committed by unknown issuers of the tokens.
On December 21, 2022, Uniswap et al. filed their respective applications for dismissal, which the Court eventually granted.
Legitimate smart contracts vs illegitimate transactions
The plaintiffs allege that Uniswap entered into a contract with them to require its users to buy and sell tokens using smart contracts established by the DeFi protocol, which the plaintiffs agreed to.
However, the Court was not convinced by these arguments. Underlining the distinction between a security and a commodity, the Order not only exonerates Uniswap from liability, but also provides a deeper analysis of today’s use of smart contracts.
below Section 29(b) of the Exchange Act:
“Any contract entered into in violation of any provision of this chapter or any rule or regulation thereunder, and any contract (…) the performance of which would involve the breach or continuation of any relationship or practice inconsistent with any provision of this chapter or any rule or regulation thereof shall be null and void… as to the rights of any person who, in breach of such provision, rule or regulation, has entered into or is involved in such contract.”
To establish a violation of this provision, plaintiffs had to show that the (smart) contract related to:
(1) A prohibited transaction
(2) Uniswap Contractual PrivacyAnd
(3) They belong to a class of persons that the Exchange Act was intended to protect.
As for the first element of “prohibited transactions”, the Court stated that rescission of such a contract is not allowed when “the breach complained of is collateral or tangential to the contract between the parties.”
Applying common law principles, the Court added that a contract can only be voided or terminated if performance of the contract is completely prevented without either party violating the Exchange Act.
Referring to the 1968 case of Eastside Church of Christ v Nat’l Plan, Inc., the Court stated that “only illegal contracts can be terminated, not illegal transactions made under lawful contracts.”
In other words, there is no logic in holding the designer or programmer of computer code underlying a particular software platform liable for misuse of that platform by a third party.
The Court compared this to a “manufacturing defect” and something more akin to a group of users trying to hold a platform like Venmo or Zelle liable for a drug deal using those platforms to facilitate a money transfer. Also used is the example of an attempt to hold a self-driving car developer liable for the use of the car by a third party to commit a traffic violation or rob a bank.
“Under those circumstances, you wouldn’t sue the car company for facilitating the misconduct; they would sue the person who committed the wrong,” Judge Failla wrote.
“There, as here, third-party human intervention causes the damage, not the underlying platform,” her statement continued.
The filing further drew parallels between the Bitcoin and Ether exchange and the operation of the smart contracts in question, acknowledging the nature of smart contracts as “self-executing, self-enforcing code” that contains the terms and conditions as agreed upon between a buyer and seller.
“Although no court has yet decided this issue in the context of the smart contracts of a decentralized protocol, the court believes that the smart contracts themselves could lawfully be executed here,” said Judge Failla.
Bitcoin and ETH labeled as commodities
Ultimately, Judge Failla refused to “expand federal securities laws to cover the alleged conduct” in the complaint, calling Bitcoin (BTC) and Ether (ETH) “commodities,” and rejected the plaintiff’s motion to dismiss.
While the US Securities and Exchange Commission (SEC) is determined to take this debate as far as possible, its chairman, Gary Gensler, remains a sight to behold when it comes to taking a clear stance on how the agency policy applies. ‘subjective’ criteria for determining whether or not a digital asset is classified as a ‘security’.
On the same day after Judge Failla’s ruling, Grayscale Bitcoin Trust (GBTC), the leading crypto asset manager, finally achieved its long-awaited legal victory over the SEC in an attempt to convert its over-the-counter GBTC application into a publicly traded Bitcoin. ETF.
The distinction outlined in the August 29 ruling certainly introduces an additional layer of complexity to the SEC’s stance on digital assets, highlighting the evolving nature of cryptocurrency regulation. As the legal landscape continues to take shape, this decision could have repercussions across the industry, triggering further discussions and possible recalibrations of regulatory perspectives.
But for now, Judge Failla’s ruling sets early precedent for how smart contracts are analyzed and how BTC and ETH are treated as commodities.
Gensler has consistently maintained that Bitcoin has the only distinction as a crypto commodity. However, the court’s recent ruling offers a contrasting perspective.
Editor’s note: This article was written by a staff member of nft now in collaboration with OpenAI’s GPT-4.