Claims Against Developers of Decentralized Exchange Dismissed as CFTC Takes Action Against Other DeFi Platforms

Practical Law Legal Update w-040-6764 (Approx. 7 pages)

Claims Against Developers of Decentralized Exchange Dismissed as CFTC Takes Action Against Other DeFi Platforms

by Practical Law Finance

Uniswap: SDNY Dismisses Action Against Decentralized Crypto Exchange

On August 29, 2023, the US District Court for the Southern District of New York (SDNY) dismissed a proposed class action lawsuit against the developers of and investors in the Uniswap Protocol trading platform, a decentralized cryptocurrency exchange, or DEX (collectively, Uniswap) (Risley v. Universal Navigation Inc. et al, ).

Plaintiffs each purchased certain tokens (scam tokens) from anonymous third-party token issuers on the Uniswap Protocol trading platform between December 2020 and March 2022 and incurred losses in connection with those purchases. The platform uses various self-executing smart contracts to execute trades which prevents users from identifying the party that issued the tokens. Since plaintiffs were unable to identify the issuers of the tokens, they took action against Uniswap for its part in facilitating the scam trades by "providing a marketplace and facilities for bringing together buyers and sellers of securities." Plaintiffs claimed that:

The transactions involving the scam token are contracts subject to rescission under Section 29(b) of the Securities Exchange Act of 1934, as amended (Exchange Act), since Uniswap operated an unregistered exchange in violation of Section 5 of the Exchange Act. Under Section 29(b), contracts that are made in violation to a rule are void.
Uniswap violated section 12(a)(1) of the Securities Act of 1933, as amended (Securities Act) for "selling" tokens through establishing the smart contract system through which the plaintiffs bought their tokens.

The SDNY granted Uniswap's motion to dismiss the suit, and found that plaintiffs failed to state a claim under the federal securities laws. The court emphasized that since the harm was caused by third-party human intervention and not the underlying platform, the protocol cannot be liable for damages, opining that:

The smart contract code that were created by the developers of the protocol are distinct from the scam tokens themselves and therefore Uniswap should not be responsible for the token contracts.
"It defies logic" that a drafter of computer code underlying a particular software platform could be liable under Section 29(b) for a third-party’s misuse of that platform.
Plaintiffs were looking for a "scapegoat" for their claims because the defendants they truly seek are unidentifiable.
Ultimately Congress should decide whether the anonymity of platform coders is troublesome enough to merit regulation.

CFTC DeFi Enforcement Actions

On September 7, 2023, the CFTC issued orders simultaneously filing and settling charges against operators of three DeFi protocols. These orders represent an expansion of CFTC enforcement efforts in the DeFi space following the CFTC's first action, earlier this year, against a decentralized autonomous organization (DAO) (see Legal Update, CFTC Granted Default Judgment Against Ooki DAO for CEA Violations).

Opyn, Inc. The CFTC entered an order filing and settling charges against Opyn, Inc., which developed and deployed a blockchain-based digital asset trading platform, the Opyn protocol, offering trading in digital asset derivatives to traders in the US and abroad, based in part on the price of ether. The CFTC alleged that, from January 2022 until approximately June 2023, Opyn violated:

Section 4(a) of the Commodity Exchange Act (CEA) by offering to enter into, or entering into, executing, and/or confirming the execution of leveraged or margined retail commodity transactions with US customers who were not eligible contract participants (ECP);
Section 4d(a)(1) of the CEA by operating as an unregistered futures commission merchant (FCM);
Section 5h(a)(1) of the CEA and CFTC Regulations 37.3(a)(1) by failing to register with the CFTC as a swap execution facility (SEF) or as a designated contract market (DCM); and
CFTC Regulation 42.2 by failing to conduct know-your-customer (KYC) diligence as required of FCMs.

Opyn did not admit or deny the findings and conclusions of the CFTC but agreed to cease and desist from all violations and pay a civil penalty of $250,000.

Deridex, Inc. The CFTC entered an order filing and settling charges against Deridex, Inc., which developed a blockchain-based digital asset trading protocol, Deridex protocol, and website that offered trading of perpetual contracts. The CFTC alleged that, from approximately January 2023 to March 2023, Deridex violated:

Section 4(a) of the CEA by offering to enter into, or entering into, executing, and/or confirming the execution of leveraged or margined retail commodity transactions with US customers who were not ECPs.
Section 4d(a)(1) of the CEA by operating as an unregistered FCM by soliciting and accepting order for swaps and leveraged or margined retail commodity transactions and accepting money or property to margin those transactions.
5h(a)(1) of the CEA and CFTC Regulation 37.3(a)(1) by operating a facility for the trading or processing of swaps without registering as a SEF or DCM.
CFTC Regulation 42.2 by failing to conduct KYC diligence as required of FCMs.

Deridex did not admit or deny the findings and conclusions of the CFTC but agreed to cease and desist from all violations and pay a civil penalty of $100,000.

ZeroEx, Inc. The CFTC entered an order filing and settling charges against ZeroEx, Inc., which developed and deployed a blockchain-based digital asset protocol, the 0x protocol, offering retail and institutional users in the US and abroad the ability to trade digital assets through the use of various blockchains.

Additionally, ZeroEx created and operated a front-end user interface called "Matcha," which utilized the 0x protocol to enable users to exchange digital assets. Using Matcha, users executed trades on a peer-to-peer basis in various digital assets, from multiple sources of liquidity. Some of the digital assets traded on Matcha were leveraged digital assets developed and issued by unaffiliated third parties. The CFTC alleged that, from approximately March 2021 to February 2023, ZeroEx conducted an office or business in the US for the purpose of soliciting or accepting orders for, or otherwise dealing in, off-exchange leveraged or margined retail commodity transactions with customers who were not ECPs in violation of Section 4(a) of the CEA because ZeroEx did not take steps to prevent non-ECPs from accessing these leveraged tokens.

It is noteworthy that the CFTC held ZeroEx responsible even though the tokens were sold on the platform by unaffiliated third parties, which, as the DeFi Education Fund advocacy group points out in a September 15, 2023 blog post, appears inconsistent with the holding in the Uniswap case (see Uniswap: SDNY Dismisses Action Against Decentralized Crypto Exchange). ZeroEx did not admit or deny the findings and conclusions of the CFTC but agreed to cease and desist from all violations and pay a civil penalty of $200,000.

Commissioner Responses to CFTC DeFi Enforcement Actions

In response to these charges, CFTC Commissioner Kristin N. Johnson issued a statement urging congressional action and regulatory intervention in order to address supervision of the growing digital asset marketplace, which she asserts currently leaves vulnerable retail customers exposed and lacking consumer protections. Commissioner Summer K. Mersinger, however, issued a statement of dissent, protesting the use of CFTC enforcement in DeFi registration failures.

Mersinger pointed out that the enforcement actions against the three DeFi developers did not include any allegations of fraud or abuse and questioning whether the CFTC had jurisdictions in the ZeroEx case. The ZeroEx protocol enabled users to execute spot trades in thousands of different digital asset trading pairs. Commissioner Mersinger pointed out that the CFTC does not have regulatory jurisdiction over this type of spot trading and the CFTC held ZeroEx liable in this case because the protocol was also used to trade some leveraged digital assets issued by unaffiliated third parties.

Commissioner Mersinger implored the CFTC to address many of the issues that were raised in the cases, including:

How DeFi protocols can properly register as DCMs, SEFs, and FCMs.
Details of how developers of DeFi protocols can be held liable for violations of the CEA.
If a DeFi protocol is developed for lawful purposes but is used for purposes that violate the CEA, should the developers be held liable?

Claims Against Developers of Decentralized Exchange Dismissed as CFTC Takes Action Against Other DeFi Platforms | Practical Law