5 key highlights of the SEC’s lawsuit against Binance

The SEC’s allegations against Binance include charges of misleading conduct, manipulative trading, diversion of customer assets and more.

The U.S. Securities and Exchange Commission (SEC) filed a lawsuit against Binance on June 5, alleging that the exchange was involved in the sale of unregistered securities. In its 136-page complaint, the SEC accuses Binance and its founder, Changpeng “CZ” Zhao, of participating in a complex conspiracy that involved fraud, conflicts of interest, a lack of disclosure and willful disregard for the law.

The claims, according to SEC Chair Gary Gensler, center on deceiving investors about risk controls, tampering with trade volumes, hiding crucial operational data, and flouting U.S. securities laws. In order to avoid regulatory scrutiny, Binance allegedly created weak controls while secretly disobeying them to keep its highly valuable U.S. customers.

Today we charged Binance Holdings Ltd. (Binance); U.S.-based affiliate, BAM Trading Services Inc., which, together with Binance, operates https://t.co/swcxioZKVP; and their founder, Changpeng Zhao, with a variety of securities law violations.https://t.co/H1wgGgR5ir pic.twitter.com/IWTb7Et86H

— U.S. Securities and Exchange Commission (@SECGov) June 5, 2023

Here are the key highlights from the SEC’s complaint:

Unregistered securities offering

According to the SEC, Changpeng Zhao has been operating Binance.com and Binance.US as exchanges, brokers, dealers and clearing agencies since at least July 2017. The complaint claims that these companies have earned at least $11.6 billion through a variety of methods, including transaction fees collected from American clients.

According to the SEC’s complaint, Binance.com should have registered as a clearing agency, broker-dealer and exchange, while Binance.US and BAM Trading should have registered as clearing agencies and exchanges, respectively. BAM Trading also needed to register as a broker-dealer, and it was charged with the unregistered offer and sale of Binance.US’ staking-as-a-service program.

Controversial practice of allowing US customers to use Binance.com

Zhao launched Binance in Shanghai in 2017, but the exchange has been elusive about where its main office is located ever since. Binance’s parent company is situated in the Cayman Islands, which makes its organizational structure more complicated. The SEC alleges that, despite publicly claiming that Binance prohibited U.S. customers from trading, the exchange surreptitiously permitted them to keep using the platform, demonstrating a deliberate disregard for U.S. securities laws.

Binance created a sizable number of user accounts for people who provided Know Your Customer identity verification information that indicated their location within the United States from the initial launch of the Binance.com platform until at least September 2019. There were also users who appeared to be physically located in the United States based on their internet protocol addresses used to access the platform.

CZ as a control person

In order to develop Binance.US, a platform serving American clients in accordance with U.S. laws, Binance and BAM Trading announced cooperation in 2019. The SEC, in contrast to Binance.US’s assertion of independence, asserts that Zhao continued to be in charge of the company.

Notably, Zhao — according to the SEC — gave Binance.US the order to onboard Sigma Chain and Merit Peak as market makers, both of which were operated by Binance employees. Since the commencement of the Binance.com platform, the Zhao-owned Merit Peak has provided over-the-counter trading services on behalf of Binance. On the Binance.com platform, Merit Peak served as the counterparty for users, and on the Binance.US platform, it offered market-making services.

Starting at least in 2021, Binance entities that were under Zhao’s beneficial control transferred billion-dollar customer assets to American bank accounts held by Merit Peak. These funds were then subsequently transferred to Trust Company A (a New York limited purpose trust company), and it appears that this transaction was related to the issuance of Binance’s stablecoin known as Binance USD (BUSD). Investors were exposed to undisclosed counterparty risk as a result of using Merit Peak as an intermediary to move client funds to buy BUSD because this relationship was not publicly disclosed.

Moreover, many of Binance.US’s bank accounts, including one that had money from American customers, had the head of the back office as the primary operator, raising questions regarding Binance’s operational openness and fund segregation.

Wash trading on Binance.US platform

According to the SEC’s lawsuit, BAM Trading and BAM Management, who are connected to Binance.US, misled both clients and equity investors about the effectiveness of market oversight and measures to identify and stop manipulative trading on the platform. However, wash trading on the Binance.US platform was a common practice. This practice artificially inflates trading volumes, providing a fictitious impression of market interest. The SEC’s charges cast doubt on the reliability of trading volume data and the openness of Binance.US’s market activities.

Even before the platform’s launch, senior officials and staff at BAM Trading were well aware of the possibility of wash trading. In correspondence sent to BAM’s CEO — presumably Catherine Coley, though she is not identified by name — and senior Binance executives, a co-founder of Binance and the head of the trade matching engine team expressed concern about the matching engine’s ability to let customers trade with themselves. However, they questioned whether it was necessary to comply with U.S./SEC regulations and prevent this manipulation.

An employee of Binance who was in charge of market surveillance was contacted by BAM Trading when it was disclosed at a meeting a year later that no measures against market manipulation had been put in place. The director of institutional sales at BAM Trading acknowledged the absence of safeguards against wash trading in January 2021. Despite Binance.US explicitly professing to forbid fraudulent trading, BAM Trading did not have transaction surveillance systems in place until February 2022.

It is also noteworthy that a sizable percentage of this wash trading activity took place through accounts connected to Sigma Chain, which served as a market maker on Binance.US. Sigma Chain’s numerous accounts and active trading on the Binance.US platform were both fully known to BAM Trading and BAM Management.

*Graphic contained in the SEC’s lawsuit depicting the alleged wash-trading volume of COTI.*

Wash trading between Sigma Chain’s accounts continued after the platform’s introduction in 2019 until at least June 2022. For instance, following the introduction of the crypto asset security COTI on the Binance.US platform on April 6, 2022, Sigma Chain quickly — the SEC alleges — became involved in extensive wash trading . Strategically, the platform’s launch, the introduction of new securities, and the funding round all fell during times when investors and equity investors were most vulnerable.

Diversion of customer assets and misuse of funds by Zhao and Binance entities

In the SEC’s lawsuit, Zhao and Binance are charged with diverting customer assets at their discretion, including sending money to the Switzerland-based Sigma Chain that is under Zhao’s control.

The SEC claimed that Merit Peak and Sigma Chain were used to transfer tens of billions of dollars between Binance, Binance.US and other connected entities. Notably, the SEC disclosed that Sigma Chain spent $11 million purchasing a yacht. The accusation raises questions about how Binance and its affiliated organizations handle customer assets and suggests money may have been improperly used.

Additionally, the SEC charged that Merit Peak’s U.S. bank account has additionally been used as a “pass-through” account since the launch of the Binance.US platform, receiving roughly $20 billion — including customer funds — from both Binance platforms. Merit Peak then allegedly transferred the majority of this money to Trust Company A, possibly for the purpose of buying BUSD. This unnoticed transfer of consumer funds to an ostensibly independent company like Merit Peak posed a serious risk because it might have left the money vulnerable to loss or theft.

The extent of the alleged misappropriation of funds and diversion of customer assets will be further looked into and scrutinized as the judicial processes progress.

Guneet Kaur joined Cointelegraph as an editor in 2021. She holds a Master of Science in financial technology from the University of Stirling and an MBA from India’s Guru Nanak Dev University.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.