Coinbase Finances Lawsuit Against US Treasury Department Challenging Tornado Cash Sanctions

Article Highlights:

• Coinbase announces financial backing of lawsuit against Treasury Department.
• The lawsuit is being brought by six individuals financially harmed by the Treasury’s recent decision to sanction Tornado Cash smart contracts.
• The lawsuit, with the support of Coinbase, represents a significant play in the ongoing chess match between the US government and the crypto industry, as the government navigates the complexities of digital asset regulation.

Overview

In the latest news on crypto-lawsuits, the largest United States-based cryptocurrency exchange, Coinbase, announced last week that the company is funding a lawsuit against the US Treasury Department.

Six individuals, including two Coinbase employees, are challenging the Department’s decision to sanction Tornado Cash smart contracts, asking that they be removed from the US sanctions list.¹ The individuals bringing forth the suit reportedly were legitimate users of the protocol, yet due to the Treasury’s decision, they are set to lose significant amounts of personal funds. The lawsuit argues that the Treasury’s Office of Foreign Assets Control (“OFAC”) is acting outside of its authority in sanctioning a technology, and in doing so, are inadvertently harming innocent users of the service.²

This announcement is a significant play in the ongoing chess match between the United States government and the digital assets world as more industry participants are pushing back against what they consider unjust regulation attempts. The Securities Exchange Commission (”SEC”) has been rapidly cracking down on crypto assets, primarily in jurisdictional claims over digital tokens they deem to be securities; their recent lawsuit against Dragonchain marked the 11th SEC enforcement action against crypto-related entities in 2022. The Department of Justice and the Commodities Future Trading Commission have also taken turns in litigation against notable crypto companies, including Kraken and Tether.³

While the agencies navigate the regulatory issues surrounding the complex industry, Coinbase joins companies such as Terraform Labs⁴ and Ripple⁵ in ensuring such regulations are fair and just by pursuing reverse legal action. Checkmate.

Tornado Cash

Tornado Cash is an open-source software built on the Ethereum blockchain that allows users to protect their financial privacy while transacting on a public network.⁶ While the nature of the blockchain technology provides publicly accessible transaction records, user identity is concealed to the extent of the custodians Know Your Customer (”KYC”) or Anti-Money Laundering (”AML”) laws, in which they verify and asses the name behind the transaction.⁷ In the instance of a data leak or hack, it is possible to link a transaction to an individual’s personal information. Enter: Tornado Cash.

Tornado Cash is a privacy solution “tumbler” or “mixer” that essentially throws deposited assets into a liquidity pool washing machine and allows users to withdraw their assets to any address using a specified key. The keys are provided in hashed form using a “zero-knowledge proof” algorithm to validate the identity of the person making the withdrawal while not compromising their privacy.⁸

“One Bad Apple..”

Despite the legitimate purpose behind the Tornado Cash protocol, it quickly gained attention from criminals and hackers because investigators couldn’t trail their illegal activity. Since 2019, the crypto mixer was used to launder more than $7 billion worth of virtual currency, leading the OFAC to consider the technology a threat to national security.⁹

The OFAC announced they had sanctioned the virtual currency mixer in a press release on August 8th, 2022. In the announcement, Under Secretary of the Treasury for Terrorism and Financial Intelligence Brian E. Nelson is quoted as saying, “despite public assurances otherwise, Tornado Cash has repeatedly failed to impose effective controls designed to stop it from laundering funds for malicious cyber actors on a regular basis and without basic measures to address its risks.”¹⁰

Tornado Cash’s smart contracts were added to the OFAC’s Specially Designated Nationals and Blocked Persons List (“SDN List”), making it illegal for any individual in the United States to use the protocol and freezing the assets currently held in Tornado Cash.

Coinbase Plays Defense

In announcing their defense of the lawsuit, Coinbase presents three arguments: (i) banning the technology harms the honest users by trapping their assets and preventing access to the “critical privacy tool,”¹¹ (ii) the Treasury’s sanction authority covers people and their property, not technology; and (iii) sanctioning open-source code creates fear and uncertainty in the eyes of developers and investors, therefore hindering innovation.¹² Coinbase expresses its commitment to protecting national security and fighting against criminal activity but says they have a responsibility to defend the crypto community.

(i) Punishing Legitimate Users

The individuals presenting the lawsuit represent the honest use of Tornado Cash, yet they are feeling the heat of the sanction caused by illicit actors. Coinbase CEO Brian Armstrong explains that one of the plaintiffs used Tornado Cash to donate money to Ukraine,¹³ and shortly after the contribution, he received suspicious air drops to his wallet. Fortunately, the anonymity of the protocol allowed him to avoid any attack on his personal information. Another is a notable crypto adopter who used Tornado Cash to protect his personal security, as his public ENS name is linked to his social media. The third individual mentioned by Armstrong operates an Ethereum staking business and was concerned for his personal safety. These innocent third parties now have funds frozen in the sanctioned protocol.

Armstrong states, “sanctioning open source software is like permanently shutting down a highway because robbers used it to flee a crime scene,” further illustrating their arguments.¹⁴

(ii) The Treasury Is Pushing Their Authoritative Limit

In a supplemental post explaining their legal arguments in detail, Coinbase claims that the Treasury was outside its jurisdiction in imposing sanctions on Tornado Cash’s smart contracts.¹⁵ The post explains that the Treasury gained the power to sanction when Congress passed the International Emergency Economic Powers Act (“IEEPA”), which authorizes 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 authority to the Treasury.¹⁶ Coinbase emphasizes that by definition, this only authorizes OFAC to sanction persons or their property.¹⁷

(iii) Scaring Away Innovation

The third presented argument explains that the privacy protocol is “critical to the development of the crypto ecosystem” and protects users from the threat of hackers and thieves. Coinbase also claims that by blocking this open-source technology, developers will shy away from future privacy projects to avoid being sanctioned for something out of their control.¹⁸

Crypto vs. Government

In 2018, the blockchain market was worth $1.2 billion and had reached $2.2 billion by 2019; PR Newswire projects that number to hit $23.3 billion by 2023.¹⁹ The industry’s explosive growth has government agencies fighting to catch up as the U.S. tries to enact appropriate regulations and promote innovation.

The SEC has been steam-rolling through the crypto industry, taking legal action against various entities for fraud, illegal securities offerings, and disclosure failures; the Commodity Futures Trading Commission (”CFTC”) labeled their method as “regulation by enforcement.”²⁰ However, cases such as the Coinbase-backed suit against the Treasury prove the industry is fighting back. Politico writer Sam Sutton phrased it as: “in 2021, the SEC went after crypto. In 2022, crypto is coming for the SEC.”²¹

Conclusion

It is unclear what will come of the lawsuit against the Treasury Department, but it is clear that clarification and unification are needed surrounding the laws governing digital assets. Perhaps we will see progress through President Biden’s March 9th Executive Order on Ensuring Responsible Development of Digital Assets, in which he called to action a whole-of-government approach to address the accompanying risk and benefits of digital assets and their technological framework. Multiple responses to the order were due this week from various agencies, and we are hopeful we are heading in the right direction towards national support of the ever-growing industry. Until then, it is safe to expect the chess match to continue.

The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Securities law is complex and highly fact specific to any given circumstance and readers should contact an attorney for advice regarding any type of legal matter.