A New York judge likely will soon have to tackle some of the thornie*st questions for regulators trying to police the cryptocurrency market.
Richard Heart, who founded and marketed the crypto token Hex, is accused by the Securities and Exchange Commission of selling unregistered securities and illegally using investor funds to buy luxury goods, including a $1.38 million Rolex watch and a 555-carat black diamond known as “The Enigma.” Heart is asking a federal judge to dismiss the SEC’s case.
The case is a test of law enforcement’s reach in policing borderless crypto transactions. It also underscores questions about liability and who—or what—can be named as defendants as the US government cracks down on decentralized finance platforms, and as currencies such as Bitcoin have once again surged in trading.
The SEC has appointed itself the “global governor of blockchain technology,” lawyers for Heart, who lives in Finland, said in an April court filing. The SEC’s response is due in the coming weeks.
Crypto users, including tens of thousands who have come to Heart’s defense, are raising concerns about the SEC naming Hex and a blockchain protocol as defendants in the suit, and the implications it could have down the road. In a filing last month, they argued those are technological innovations that can’t be sued.
Legal scholars agree the SEC’s approach appears new.
“This is a case of technology moving faster than the law,” said Michele Neitz, a professor at the University of San Francisco School of Law and the founder of the Blockchain Law for Social Good Center.
‘Can’t Sue the Sidewalk’
Financial regulators have increasingly set their sights on decentralized finance, or DeFi.
The Commodity Futures Trading Commission brought enforcement actions in September against three DeFi firms and signaled more may be coming. The SEC is also investigating Uniswap, the creator of the largest DeFi trading platform on Ethereum, for securities law violations.
The nature of the technology poses tricky questions for regulators. The SEC alleges Hex, which trades at a fraction of 1 cent, is both a security and an entity. Heart and crypto users dispute both interpretations.
“So much of it is the fact that it could be a security, it could be a currency, and then it could be an entity, that makes it confusing and hard to get your arms around,” said Carliss Chatman, a Southern Methodist University Dedman School of Law professor who teaches business and commercial law.
The SEC has also named as defendants, along with Heart and Hex, the PulseChain blockchain network and PulseX, a decentralized finance platform. The SEC alleges Hex and the other software are “unincorporated alter-ego entities” of Heart.
Suing computer software is “bizarre,” and the SEC’s legal theories are “novel and unsupported,” PulseChain users said in a filing last month.
“You can’t sue the sidewalk, or a piece of software,” users said in the brief, authored by Jenner & Block LLP partner Kayvan Sadeghi and Nick Morgan, a former SEC attorney and founder of the Investor Choice Advocates Network.
‘Nightmare Scenario’
The SEC’s reasons for including the token and network as defendants are unclear. But users fear it’s an attempt to effectively shut down PulseChain and Hex, which have amassed a significant following.
Some blockchain attorneys say the agency’s approach could open the door to developers being held liable for the computer software they write. The SEC’s investigation of Uniswap has triggered similar concerns.
Allowing the SEC to proceed with the case would create a “cloud of uncertainty about what conduct may or may not ultimately be deemed to violate the federal securities laws (and what inanimate technology might somehow be deemed liable for any violation),” the users’ brief said.
The SEC isn’t the first regulator to advance what critics have called novel, and concerning, arguments in this area.
The CFTC in 2022 won a ruling that a so-called decentralized autonomous organization, the Ooki DAO, could be sued as an unincorporated association. DAOs are blockchain-based groups controlled by their members.
The CFTC had served the DAO with notice of the suit by posting a copy of the complaint in an online chat box and help forum, which various crypto groups argued was improper.
In another case, a judge allowed crypto users to sue a related DAO as a general partnership. The ruling put thousands of members of the group at risk of being held personally responsible in the suit, which the parties later settled.
These types of cases underscore lingering uncertainties about how the new technologies fit into traditional legal concepts, and the extent of potential legal risk for DeFi participants, attorneys say.
“I think people starting crypto and DeFi were hoping that you’d have even greater protection because there’d be no entity at all,” said Stephen Rutenberg of Polsinelli PC, who focuses on cryptocurrency and blockchain technology.
“But the nightmare scenario,” Rutenberg said, “is you lose even the corporate protection and you become basically a partnership where everyone is responsible for everything.”
SEC’s Global Reach
Another question in the case is whether Heart can be sued in the US.
The SEC’s lawsuit against Heart, filed last summer, was brought in the US District Court for the Eastern District of New York. The SEC alleges Heart raised more than $1 billion by selling unregistered securities. He is accused of using at least $12.1 million of investor funds for personal luxury purchases.
Making his own pitch for dismissal, Heart said the court doesn’t have jurisdiction to hear the case.
The SEC didn’t allege he has US offices or bank accounts or that he visited the US. Rather, the complaint points to an undetermined number of US users, as well as YouTube videos and other social media posts.
“When do US courts have the ability to hear disputes involving these kinds of borderless transactions?” said Jonathan Schmalfeld, a Polsinelli attorney focused on blockchain and other technologies. “Or in this case, would the more appropriate court, whether it’s a government agency or private individuals or anybody else, be Helsinki?”
Additionally, Heart said there weren’t the kinds of US securities transactions that would give the SEC authority.
The SEC’s complaint merely points to an “unidentified resident of Brooklyn” and other unspecified US investors as having sent crypto assets to a blockchain address associated with PulseChain, Heart said.
Citing one anonymous person in Brooklyn sending funds “is pretty stark in comparison to how usually you would analyze whether the SEC has jurisdiction over a securities matter,” Schmalfeld said.
The case is Securities and Exchange Commission v. Schueler, E.D.N.Y., No. 23-cv-05749.
