SEC Takes Legal Action Against Binance and CEO Changpeng Zhao: What Led to the Lawsuit?

The U.S. Securities and Exchange Commission (SEC) has taken legal action against Binance and its CEO, Changpeng “CZ” Zhao, alleging violations of federal securities laws. The lawsuit states that Binance, Binance.US, and CZ unlawfully provided unregistered securities to the public, specifically the BNB token and Binance-linked BUSD stablecoin. Additionally, the suit alleges that Binance’s staking service violated securities laws.

The charges extend to BAM Trading, the operating company for Binance.US, and Binance, including accusations of failure to register as a clearing agency, as a broker, and as an exchange. In addition, the SEC claimed that Binance permitted the commingling of customer funds and accused CZ of covertly controlling Binance.US. The lawsuit further alleged that a CZ-owned entity artificially inflated Binance.US’s trading volume.

SEC’s Serious Allegations

The suit asserted multiple instances where Binance facilitated trading for U.S. persons, despite explicitly stating otherwise. According to the lawsuit, as a part of Zhao’s and Binance’s strategy to evade U.S. regulatory oversight, they consistently made public statements asserting that the Binance.com Platform did not cater to U.S. individuals. However, simultaneously, they concealed their efforts to enable their most valuable U.S. customers to continue trading on the platform.

Furthermore, the SEC stated that upon the launch of the Binance.US Platform in 2019, Binance publicly declared the implementation of controls to prevent U.S. customers from accessing the Binance.com Platform. Contrary to these claims, the suit states that Binance took the opposite approach. Zhao specifically instructed Binance to covertly aid certain high-value U.S. customers in bypassing these controls, acknowledging that Binance aimed to avoid being held responsible for these actions.

The SEC also made allegations regarding several other tokens, such as the native coins associated with the Solana (SOL), Cardano (ADA), Polygon (MATIC), Coti (COTI), Algorand (ALGO) blockchains, as well as the Filecoin network (FIL), Cosmos hub (ATOM), Sandbox platform (SAND), Axie Infinity (AXS), and Decentraland (MANA). The lawsuit also cited a conversation between Binance’s Chief Compliance Officer and another employee in 2018, where the officer stated, “we are operating as a fking unlicensed securities exchange in the USA.”

Inadequate Financial Controls and Funds Diversion

According to the lawsuit, Binance’s inadequate financial controls resulted in the diversion of customer funds, potentially for personal purposes. The suit alleged that Merit Peak Limited, a market maker previously associated with Zhao, had access to billions of U.S. dollars of customer funds. Additionally, Sigma Chain, another entity controlled by CZ, reportedly received approximately $200 million from BAM Trading and a BAM Trading custody account.

In a span from October 2022 to January 2023, CZ himself allegedly received $62.5 million personally from one of the Binance bank accounts. The lawsuit further claimed that due to the lack of regulatory oversight, the defendants had the freedom to transfer investors’ cryptocurrency and fiat assets as they pleased. Defendants were accused of commingling and diverting these assets in ways that would not have been permissible for properly registered brokers, dealers, exchanges, and clearing agencies.

The SEC disclosed that Sigma Chain used customer funds to purchase an $11 million yacht, as stated in the lawsuit. The suit further revealed that CZ was the sole owner of “CPZ Holdings Limited,” which, in turn, held 100% ownership of “BAM Management Company Limited.” In collaboration with seed investors and former employees, the latter entity owned 81% of “BAM Management US Holdings Inc.” This structure ultimately resulted in BAM Management US serving as the parent company of BAM Trading Services, which operates Binance.US.

Internal struggles within the U.S. operations were also brought to light by the SEC, involving CZ and top Binance officials exerting control over the U.S. operations despite assurances of independence. The U.S. operations voiced concerns about the limitations imposed on their managers, requiring them to seek approval from the global company for even basic functions, likening it to “shackles.”

“I realized, huh, I’m not actually the one running this company, and the mission that I believe I signed up for isn’t the mission. And as soon as I realized that, I left,” stated the former U.S. CEO Brian Brooks, identified as “CEO B” in the lawsuit. Brooks, who had previously served as the head of the U.S. Office of the Comptroller of the Currency, resigned from his position at Binance’s U.S. division after just three months.

His concerns were particularly focused on the activities of Merit Peak and Sigma Chain on the Binance.US platform. Brooks also mentioned: “Our customers couldn’t, you know, clear orders without the presence of those makers on our platform, I thought that was a real problem. It suggested that the company was, in fact, heavily dependent on CZ, not just as a control person but also as an economic counterparty.”

According to the lawsuit, Catherine Coley, identified as “CEO A,” expressed internal grievances by stating that her “entire team is at their breaking point.” Coley, the initial CEO of the U.S. operations, attempted to pursue a project referred to as “Project 1776,” alluding to the American Revolution. In a conversation with a colleague, she described it as a means to achieve “our independence,” as per the lawsuit.

Binance’s Response to Regulatory Concerns

The SEC lawsuit includes references to the “Tai Chi” documents, which were originally reported on by Forbes in 2020. These documents outlined a plan for Binance to officially exit the U.S. market while maintaining a presence through an affiliate. According to the lawsuit, Binance employees were found discussing methods to enable U.S. customers to trade on binance.com, despite the company’s claims to the contrary.

Another concern raised by the SEC was that Binance had access to Binance.US’s wallets, assets, custody tools, and private keys, as alleged in the lawsuit. The SEC also claimed that Binance engaged market makers, particularly Merit Peak and Sigma Chain, to artificially boost trading volume on Binance.US. According to the SEC’s allegations, this arrangement created conflicts of interest between CZ, Binance, and Binance.US’s customers.

The SEC alleged that BAM Trading, in order to establish and maintain liquidity on the Binance.US Platform, recruited market-making firms and other institutions, often offering them low fees as incentives. According to the SEC, Zhao and Binance played an integral role in these endeavors, leading to a conflict of interest between Zhao’s financial interests and the customers trading on the platform under his control.

The lawsuit also highlighted that Binance.US operated its own OTC (Over-The-Counter) desk, and during a two-year period, Alameda Research, founded by FTX creator Sam Bankman-Fried, was its sole counterparty. It is worth noting that Alameda Research and the broader FTX empire experienced a collapse in November of the previous year, as mentioned in the suit.

Claiming to be Caught in a U.S. Regulatory Tug-of-War

Binance.US responded to the lawsuit with a lengthy tweet, characterizing it as an instance of “regulation by enforcement” and asserting that the company deemed the suit to be “baseless.” Binance also issued a statement on its blog, emphasizing its active cooperation with the SEC’s investigations, diligent efforts to respond to inquiries and address concerns, and commitment to working towards a settlement.

Binance’s official statement said: “The SEC’s actions here appear to be in service of an effort to rush to claim jurisdictional ground from other regulators – and investors do not appear to be the SEC’s priority. Because of our size and global name recognition, Binance is an easy target now caught in the middle of a U.S. regulatory tug-of-war.”

In an official press release, SEC Chair Gary Gensler stated that the SEC’s allegations, comprising thirteen charges, highlight the involvement of Zhao and Binance entities in a wide-ranging network of deceit, conflicts of interest, non-disclosure, and deliberate efforts to evade the law. The SEC lawsuit builds upon the previous allegations made by the U.S. regulator Commodity Futures Trading Commission (CFTC) in March of this year.

The CFTC accused Binance and its founder Changpeng Zhao of knowingly providing unregistered cryptocurrency derivatives products in violation of federal laws. Numerous similarities between the allegations presented in the SEC’s lawsuit and the CFTC’s complaint can be observed. In response to the news, CZ took to Twitter and posted a tweet with the number “4,” essentially dismissing the information as “fud” (an acronym for fear, uncertainty, and doubt).

SEC Seeks Legal Remedies and Penalties

The SEC has filed a motion to halt Binance, Binance.US, and “all respective agents” from further violations of federal laws. In addition, the SEC seeks to compel the defendants to disgorge any “ill-gotten gains” along with prejudgment interest and pay civil penalties. Furthermore, the SEC aims to prevent CZ from serving as an officer or director of any securities issuer.

The commission also intends to prohibit Binance, Binance.US, and CZ from participating in or trading any securities, including crypto asset securities. The lawsuit also specifies that the defendants should be barred from acting as an unregistered broker, clearing agency, or exchange dealing with any crypto asset securities.

Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, said: “We allege that Zhao and the Binance entities not only knew the rules of the road, but they also consciously chose to evade them and put their customers and investors at risk – all in an effort to maximize their own profits. Despite their years-long efforts to not ‘be held accountable,’ today’s complaint begins the process of doing so.”

According to Gurbir S. Grewal, it is alleged that the Binance platforms, under the control of Zhao, engaged in multiple unregistered offerings while neglecting to register themselves. The lack of transparency, reliance on transactions with related parties, and false claims about implementing safeguards against manipulative trading further exacerbate these risks and conflicts, as stated by Grewal.

Market Response to SEC Lawsuit Against Binance

Despite the SEC filing a lawsuit against Binance and its founder, CZ, for alleged violations of federal securities laws, the crypto markets displayed no signs of slowing down on Tuesday. Data obtained from Nansen.ai reveals that over a 24-hour period, there were outflows totaling $719 million from Binance across all protocols.

Particularly during U.S. trading hours, net outflows amounted to $230 million following the SEC’s announcement of the lawsuit against Binance. Although the net outflow from Binance appears substantial and continues unabated, data from Nansen indicates that Binance’s stablecoin balance remains robust.

The exchange presently holds stablecoins totaling slightly above $8 billion, with a seven-day outflow of $519 million, accounting for approximately 6% of its holdings. Comparatively, OKX, the exchange with the second-largest holdings, has a balance of $4 billion. In a series of tweets, CryptoQuant, a crypto analytics firm based in Seoul, highlighted that the withdrawal figures fall within the range of historical norms.

The long-term impact of the SEC lawsuit on Binance and the broader cryptocurrency market remains uncertain. It highlights the increasing regulatory scrutiny faced by crypto exchanges and the need for compliance with securities laws. As the legal proceedings unfold, the outcome of the case will likely shape the regulatory landscape for the crypto industry and influence investor confidence in cryptocurrency exchanges.