The Breakdown - Courts Hand SEC Half an L in Binance US Case

Episode Date: September 20, 2023

NLW catches up on the latest legal details of the SEC's battle against the zombie exchange Binance US. The judge recently denied an SEC request to compel Binance US to produce specific information, and NLW explores how big a deal it was and where it leaves things in the case now. Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Tuesday, September 19th. And today, we are talking about Binance and their SEC court decision yesterday. Is it significant? Is it just kicking the can down the road? We will go through all of that. Before we do, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to be a, want to dive deeper into the conversation. Come join us on the Breakers Discord. You can find a link in the show

notes or go to bit.ly slash breakdown pod. Well friends, it is a day that ends in why, so there is, of course, another Binance story. Binance had a fairly big day in court on Monday in their legal battle with the SEC. Leading into the hearing, the allegations and speculation had started to reach a fever pitch. The SEC had begun to hone in on the theory that Binance US did not and never had exclusive control over customer assets. That, if true, would be a big deal, as Binance had always maintained, that U.S. customer assets were strictly segregated from the international exchange. Indeed, they used this argument to defend an SEC injunction shortly after the legal proceedings commenced in June. If granted, the injunction would have frozen assets at Binance U.S., which would

have functionally been a death sentence for the domestic exchange. In deciding that injunction, the court ordered the parties to come back with an agreement that they could both live with, rather than making a decision on their own. As part of those consent orders, Binance agreed that they would ensure that only local U.S. staff would have access to customer assets. However, as the SEC dug further into their investigation, they claimed that Binance U.S. used a custody system called Seifu, Cepfu, which they viewed as intimately linked to Binance International.

Seifu was launched under the name Binance custody in December 2021. It was renamed in February of this year, around the same time that rumors of an in-depth government investigation into Binance, first emerged. On Friday, Sefhu asserted in a press release that they were entirely separate from Binance International and that they don't even service BAM trading, which is the company that operates Binance U.S. They wrote, In its filing on September 14th, the SEC claims that Sefu has provided third party, quote, wallity custody software and support services to BAM. We strongly reject this claim. As a custody technology

services provider under Sefu Holdings, we are committed to servicing institutional clients with digital asset custody solutions in select jurisdictions, excluding the United States, among others. Furthermore, Sefhu's operations and services are distinctly separate from BAM and Binance Holdings Limited, end quote. A Sefu spokesperson added that, quote, Sefu is not a Binance entity. Prior to rebranding in February 2023, our entity was always run independently from Binance activities and thus fully separate from Binance. Unfortunately, earlier in the week, Binance U.S. had contradicted parts of that claim in a legal filing. than denying the use of Sefu in their operations, Binance U.S. acknowledged that the service was developed

by Binance International and licensed to the U.S. entity. And while the specific origin of the Binance U.S. custody system might seem like a minor detail, this is the main focus of the lawsuit at the moment. The SEC is claiming that Binance International had de facto control over customer funds at the U.S. exchange. If that's the case, then Binance could be viewed as deliberately misleading the court surrounding this issue. It would also advance the SEC's argument that Binance U.S. was nothing more than a front to allow U.S. customers to access the international exchange and provide a veneer of domestic regulatory compliance. So that's a bit of the background. Now, on Monday morning, the SEC filed additional material to support their order, which asked

the court to compel Binance to cooperate with the discovery process. They said, quote, the limited inspection the SEC has been able to conduct so far demonstrates the urgent need for an inspection. Indeed, in earlier filings, the regulator had raised issues surrounding the lack of disclosure. They noted that Binance had only produced 220 documents, many of them characterized as, quote, unintelligible screenshots and documents without dates or signatures. Further, according to the SEC, Binance U.S. were resisting the deposition of a number of key executives. In a court filing in August, Binance claimed that the deposition of CEO Brian Schroeder would be, quote, disruptive to BAM's business and called the entire discovery process a fishing expedition. You'll remember that Schroeder

was confirmed to have left the company in early September, although his lack of social media presence has led some to speculate that his departure was closer to the beginning of the year. The SEC appears to have been informed of Schroeder's departure only recently and clearly haven't recruited him yet as a cooperating witness. They said that this strange turn of events and Binance has continued resistance to producing Schroeder, quote, raises the question of whether anyone other than CZ and Binance has ever exercised control over Bam and its assets. Now, the SEC was primarily concerned that Binance US was continuing to use Seifu for its custody, which could be used to shift customer assets offshore.

They said that Binance US had failed to convince the regulator that they had control over customer assets, adding that these claims were, quote, undermined by BAM's own documents and inability to keep its story straight, which did not actually establish that BAM exercised exclusive control over its customers' assets. The SEC said that so far Binance U.S. had provided, inconsistent representations about key facts, slow-rolled small productions of documents and information, and stonewalled on entire categories of information that would likely shed light on its shaky assertions concerning the custody of customer assets. They said that, quote, BAM insists that this court like the SEC should accept packaged counsel narratives,

carefully drafted declarations, and small curated sets of documents regarding control of BAM's customer assets, and that any lingering concerns are much ado about nothing. To top it all off, the SEC warned that Bynance CEO, CZ is, quote, an individual who views himself outside the jurisdiction of any court. The SEC claimed that they have demonstrated that, quote, Binance has a long history of controlling BAM to serve Binance's own unlawful purpose. Ultimately, the regulator asked the court for an order, quote, compelling BAM to produce documents and communications concerning any entity providing it with wallet custody software and related services. They urged the court to reject Binance's, quote, half-hearted claims of irrelevance,

and burden. Now, in their opposing court filing placed on the record on Monday morning, Binance U.S. reiterated their claim that SEC demands were unreasonable. They called the documents requested overbroad and too much of an inconvenience. Binance U.S. further alleged that many of the documents requested are either not in the exchange's possession or fall outside the scope of the lawsuit. At 3 p.m., the parties entered the courtroom for what would be a tense hearing. Binance U.S. called the demand for documents so broad they would be impossible to produce. A lawyer representing the exchange said that, quote,

chasing down exactly how that software works is neither here nor there. The judge indicated that Binance U.S. really would need to provide a bit more documentation of their custody arrangements. They said, I think we need more than we've got right now, adding that they weren't, quote, super confident that Bam has total control of their assets. The SEC lawyer, meanwhile, explained that the problem at the moment was that, quote, we don't know what we don't know. They argued that the SEC needed much more information about the wallet set up at Binance US than they currently have. At one stage, the attorney for Binance exclaimed, that is foolish, it's not serious litigation.

They said that the exchange had responded to every targeted request from the regulator. The lawyer added that, quote, what we are not going to respond to is this. foolishness of document requests that came from the government here. So what came out of all of this? Well, ultimately the judge declined to make any orders to compel discovery from Binance, but it was made clear that the exchange would need to increase its cooperation, let's say. The judge said that they were not, quote, inclined to allow the inspection at this time, adding that, quote, I'm not going to order from the bench right now that they produce or not produce things. Let's continue to try to work this out. I just want to keep things moving.

The judge also noted that, quote, at some point we're going to have to bite the bullet and move on with this case. As investor Adam Cochran summed it up, the judge did deny the inspection, but also said they needed Binance US to comply and produce more documentation, as the judge was not convinced of the asset backing. This is saying the inspection is overkill for now and giving Binance the chance to comply. Now, ultimately, these issues around Sioux are largely still about litigating whether the assets of Binance US should be frozen to prevent customer funds from being sent offshore. However, given that volumes on the exchange have collapsed by more than 99% over the past six months, it seems likely that users have largely taken that issue off the table already.

The matter is scheduled to return to court on October 12th for a follow-up hearing. Now, outside of the hearing, the court docket continues to blow with additional evidence gleaned by the SEC. Much of this evidence was originally filed under seal or in a heavily redacted form, but the regulator is currently in the process of unsealing documents. Earlier this month, the SEC obtained the cooperation of the former auditor for Binance U.S., which produced in excess of 6,500 pages on the accounting at the exchange. The document was unredacted on Monday, revealing the auditor's conclusion that it was, quote, very difficult to ensure the company

was fully collateralized at specific points in time. One of the SEC's request for further information filed in June, related to a $250 million intercompany loan given to Binance U.S. by the International Exchange in December of last year. The convertible note was funded using BUSD, 183 million of which was sent to Paxos to convert into dollars. The SEC wanted some additional details about the reason for this transaction. The topic was initially flagged as confidential by Binance, but that designation was apparently successfully rebutted by the SEC. Now, there was a lot of chatter on this on Twitter. With many people taking it as evidence of some smoking gun, the Binance had been less

than honest about their dealings with Binance US. Perhaps the most intriguing tidbit, however, filed recently was a declaration given by Jay Emmett Murphy of the SEC's trial division. The document document again filed on Monday, introduced into evidence three additional depositions. All three were filed under seal, but were used to support the need for further examination of the Sefu system. The declaration identified one witness as Eric Kellogg, Bam's chief information security officer, but the other two identities were redacted. All three depositions occurred over the last month, with the latest taking place last Wednesday. So here's the way that Adam Cochran summed this all up, which I think is a pretty good TLDR. He tweets,

SEC seeks court order for inspection of Binance U.S., now expressly calling out that Sefu is indeed a Binance-related entity and that Binance U.S. has been misleading the court. The SEC calls out that this violates the consent decree that required new wallets expressly away from Binance International Control and Access, but interestingly specifically notes this is important as Binance has controlled BAM for its, quote, own unlawful purposes. That's a claim we've not seen the SEC lobby here before, at least not outside of anything sealed or redacted. We also learned for the first time that the SEC sought the testimony of Brian Schroeder, US CEO, and Jasmine Lee, US CFO, but have been denied and fought on that,

and only just got told that Trotter is no longer CEO, despite Schroeder being missing for eight plus months. They had argued that Trotter's testimony would be too disruptive to business and now got told he isn't on the job. Which is wild, as I think we all assumed he pulled a Catherine Coley, Brian Brooks, and gave testimony. Seems he's just disappeared and gone silent. Either way, the SEC here is suggesting, one, there is evidence of crimes, two, there is indeed evidence that Cephew is BINCE International, three, Cepu is not simply a wallet provider, and four, BAM executives themselves lack insight on Binance U.S. assets and tooling. Now, for completeness, Adam Cochran also tweeted about the deposition from the auditor that said that it was impossible to tell

whether Binance U.S. had been fully collateralized at specific points in time. He said, if your own external auditor can't say you are fully collateralized when you are supposed to be a 100% reserves exchange and have your own proof of reserves that claim you're over-collateralized, that is a problem. Finance uses the Sefu Wallet Custody system, previously Binance Custody, for both Binance International and Binance US, as noted in their filings. If this system is not capable of managing the small Binance US numbers, how could it keep track of international? And if Binance US, its more compliant exchange never commingled or misused client funds and was isolated from international as they claim, that it would be literally impossible to have a gap.

The only way this is possible is the misuse of customer funds resulting in losses. I believe at some point in their scaling, they had material losses when misusing customer funds and exposing themselves to leverage via B&B. They've continued to misuse customer funds to try and cover this hole, but a declining market has made that an ongoing shell game. Whether you think that is a fair assessment or not, there should at this point be absolutely no doubt that the correct risk model is to move your assets off of Binance.

Now, for the sake of a counterpoint, Bruce Fenton tweeted this morning, Binance is perhaps the most scrutinized and attacked company in modern history. The United States has investigated them and thrown everything they can at them. Yet despite all this, we don't have a single accusation let alone evidence that Binance has lost customer funds. Now, trying to wrap this all up, a lot of the commentary around this is trying to figure out if the SEC won or lost this court trip.

Will Clemente from Reflexivity Research tweeted, courts have been handing the SEC L after L lately, but others aren't so sure. CZ certainly didn't think so, retweeting someone who wrote, seems like they can't find anything, but they want to continue making headlines. Maybe the most middle-of-the-road interpretation came from the headline from Bloomberg,

which read, SEC fails to win immediate inspection of Binance US software, and I think that that fails to win is probably a better representation at this point than actually getting the loss. But my friends, as you can tell, we are well in the minutia of this, but the details matter. There certainly is a feeling of crescendo to this story, and either way, it's hard for me to imagine that the industry isn't better on the other side of it. Better because Binance is vindicated, or better, unfortunately, because the last giant has fallen and we can finally move on largely rid of what came before. In either case, I will be

sure to keep you updated. So until next time, be safe and take care of each other. Peace.