Complex Civil and Criminal Cases Converge

On August 17, 2023, Judge Robert Pitman of the federal district court for the Western District of Texas issued an Order granting summary judgment for the U.S. Treasury Department (“Treasury”) in a lawsuit brought by six individuals, and denying the cross-motion for summary judgment filed by the individuals. The lawsuit alleged that Treasury overstepped its authority by imposing sanctions on the coin mixing service Tornado Cash.  Deciding for the government, Judge Pitman determined that Tornado Cash is a “person” that may be designated by OFAC sanctions.  Specifically, the regulatory definition of “person” includes an “association,” and Tornado Cash is an “association” within its ordinary meaning.

Shortly thereafter, on August 23, 2023, the U.S. Department of Justice (“DOJ”) unsealed an indictment returned in the Southern District of New York against the alleged developers of Tornado Cash, Roman Storm (“Storm”), a naturalized citizen residing in the U.S., and Roman Semenov (“Semenov”), a Russian citizen.  The indictment charges them with conspiring to commit money laundering, operate an unlicensed money transmitting business, and commit sanctions violations involving the International Emergency Economic Powers Act, or IEEPA.  When the indictment was unsealed, Storm was arrested and then released pending trial.  Treasury simultaneously sanctioned Semenov, who remains outside of the U.S., adding him to OFAC’s Specially Designated Nationals and Blocked Persons (“SDN”) List.

These are very complicated cases raising complicated issues.  They are separate but obviously related.  As we will discuss, the factual and legal issues tend to blend together, and how a party characterizes an issue says a lot about their desired outcome:  has the government taken incoherent action against a technology, or has it pursued a group of people attempting to hide behind tech?

Background: Sanctions Imposed on Tornado Cash

On August 8, 2022, the Office of Foreign Assets Control (“OFAC”) alleged that Tornado Cash, a virtual currency mixer operating on the Ethereum blockchain, of laundering more than $7 billion of cryptocurrency since its inception in 2019.  OFAC further alleged that Tornado Cash was a key tool used by North Korea’s Lazarus Group to launder $455 million worth of stolen crypto funds.  Accordingly, Tornado Cash was added to the SDN List, thereby creating an outcry within the digital assets industry.  On November 8, 2022, OFAC rescinded its original designation and simultaneously re-designated Tornado Cash, in order to add an additional basis for its action pertaining to the alleged use of Tornado Cash by North Korea to launder the illicit proceeds of cybercrime and theft of digital assets.

Tornado Cash is a mixing service that combines various digital assets, potentially including funds obtained illegally with legitimately obtained funds.  The putative reason for this service is to enhance privacy. According to Treasury, the increased anonymity and complexity in tracking funds flowing through Tornado Cash begs to be exploited by bad actors. OFAC claimed that Tornado Cash had inadequately prevented its misuse for malicious cyber activities/.  This assertion, which implies that actual people run Tornado Cash, is the crux of the controversy: can OFAC act directly against technology such as open-source code?  As we discuss below, the government wants to reframe this question, to resemble the following: can OFAC act against a technology when it is packaged and offered as a business service by an association of people?

District Court Rules for Treasury

On September 8, 2022, six plaintiffs filed a complaint against OFAC and Treasury, asking the court to declare OFAC’s addition of Tornado Cash to the SDN List as unlawful, and permanently enjoin the enforcement of the designation and any sanctions stemming therefrom. (See our prior blog post here.) Plaintiffs alleged that OFAC violated the Administrative Procedures Act and the First Amendment’s Free Speech Clause.  They also alleged that OFAC had violated the Fifth Amendment’s Takings Clause as to those plaintiffs whose virtual currency was effectively trapped in Tornado Cash’s smart contract pool.  In his Order, Judge Pitman rejected each claim.

Plaintiffs had asserted that Tornado Cash, being an open-source, decentralized, software project made up of a network of automated smart contracts without any specific ownership, did not constitute a “person” or “property” as outlined in IEEPA.  Essentially, Tornado Cash, plaintiffs argued, is software, not a legal person or entity as defined by IEEPA.  Accordingly, OFAC lacked the statutory authority to designate Tornado Cash.

The court rejected this assertion.  The court reasoned that Treasury had defined the term “person” through its regulations to mean an “individual or entity,” and that Treasury in turn had defined “entity” to include “a partnership, association, trust, joint venture, corporation, subgroup, or other organization.”  The court further found that Tornado Cash has characteristics of an “association,” under the plain meaning of the word.  The court noted that Tornado Cash is comprised of its founders and developers, who research and publish code, and the related decentralized autonomous organization (“DAO”), which is responsible for governing the platform and derives revenue from its operation.  Utilizing this structure, the court noted, Tornado Cash has been able to advertise and compensate its contributors and “relayers,” who provide customers with enhanced anonymity in exchange for a fee.  The court reasoned that this conforms with the ordinary meaning of “association”, namely, “[a] body of persons who have combined to execute [the] common purpose” which, in this instance, is to develop, promote, and govern Tornado Cash.

Plaintiffs had argued that Tornado Cash does not satisfy the definition of an “association” because, “to the extent that Tornado Cash has any organizational structure, its structure does not even satisfy the definition of [an] unincorporated association.”  Plaintiffs argued that Tornado Cash is merely autonomous software.  The Court disagreed, stating that the founders, the developers, and the DAO acted in concert to promote and govern Tornado Cash. 

Plaintiffs also argued that there is no evidence that the individual members of the DAO established common purpose, because the DAO is composed of anyone that owns a “TORN” token, the native governance token for Tornado Cash used for voting on decisions.  According to the Order, “[t]he smart contracts generate fees in the form of TORN tokens for the DAO when users execute a relayer-facilitated transaction.”  The court rejected plaintiffs’ claim and found that the DAO is an entity unto itself, which, through its voting members, has demonstrated an agreement of common purpose.  Additionally, the court concluded that the DAO possessed a property interest in the smart contracts because the DAO provided Tornado Cash with a means to control and use crypto assets.  The DAO received income streams from these smart contracts, with the expectation that deployed smart contracts would continue to generate revenue.  As we will discuss, the DAO also figures prominently in the allegations set forth in the indictment. 

The court similarly dismissed plaintiffs’ claim that Tornado Cash’s designation infringed on constitutionally protected free speech.  Plaintiffs argued that the government prohibited them from engaging in socially valuable speech because, if not for the designation, they would use the Tornado Cash software to make donations to important political and social causes.  The court found this argument weak, pointing out that plaintiffs did not adequately explain how their speech was being restricted since there are other ways to support causes anonymously. Plaintiffs also claimed that the designation affected the publishing of source code.  This too was rejected by the court, stating that the restriction only pertained to using code for transactions, while other uses of the code were not restricted and did not raise First Amendment concerns.

Finally, Judge Pitman did not address plaintiffs’ argument based on the Takings Clause, determining instead that the argument had been waived for failure to raise it in their motion for summary judgment. 

Ultimately concluding that Tornado Cash is a “person” that can be designated by OFAC, the court dismissed the lawsuit.

Alleged Tornado Cash Co-Founders Indicted

Six days after the verdict in favor of Treasury, the DOJ unsealed an indictment charging alleged Tornado Cash co-founders Storm and Semenov with conspiracy to commit money laundering, operate an unlicensed money transmitting business, and violate IEEPA.  In a coordinated effort with the DOJ, Treasury also sanctioned Semenov, adding him to the SDN List, as well as the cryptocurrency addresses connected to him.  The third alleged co-founder of Tornado Cash, Alexey Pertsev was arrested on related money laundering charges in the Netherlands last year; the indictment repeatedly refers to the conduct “CC-1,” which presumably stands for “Co-Conspirator 1” and likely refers to Pertsev.

The indictment alleges that Storm and Semenov developed, marketed, and operated Tornado Cash, knowing that a substantial portion of the funds processed were criminal proceeds passed through Tornado Cash for purposes of concealment.  Further, Storm and Semenov allegedly knew that Tornado Cash received funds from, and provided services to, the sanctioned North Korean cybercrime organization, the Lazarus Group.  (See our other blog posts relating to the Lazarus Group here and here.)  Additionally, Tornado Cash operated without any Know-Your-Customer (“KYC”) or anti-money laundering (“AML”) programs, and did not register as required with the Financial Crimes Enforcement Network (“FinCEN”) even though, according to the indictment, it represented a “money transmitting business” and therefore a “financial institution” regulated under the Bank Secrecy Act (“BSA”).  According to the indictment, over $1 billion in criminal proceeds were laundered through Tornado Cash.

The indictment is lengthy and detailed.  It paints a picture of Storm, Semenov and CC-1 working in concert to operate and market a for-profit business.  Its allegations mirror the arguments of Treasury in the civil case that Tornado Cash not merely a technology existing in a vacuum, but, properly understood, represents an informal association of business partners.

A key issue in the criminal case will be “control,” and the indictment indeed alleges that Storm and Semenov “initially” exercised “complete control” over Tornado Cash and maintained the private keys for the Tornado Cash smart contracts.  In or about May 2020, they allegedly updated the smart contracts by removing their private keys, thereby preventing further modification by others. Further, Storm and Semenov created the DAO in December 2020 to vote on governance decisions for Tornado Cash, while retaining control over the operation and design of the user interface.  Additionally, Storm and Semenov allegedly promoted Tornado Cash for its ability to provide customers with anonymous transactions, and advised customers on how to ensure further anonymity by utilizing TOR and VPN, deleting data from their web browsers, and leaving their money in Tornado Cash for longer periods of time to better anonymize their transactions.

The indictment points to several instances where Storm and Semenov had received complaints from customers of Tornado Cash who were victims of hacking, yet they declined to offer assistance.  Despite knowing that criminal proceeds were being comingled with legitimate funds, the indictment charges that Storm and Semenov did not take steps to implement any AML or KYC controls.  To the contrary, one particularly colorful allegation in the indictment describes an encrypted exchange between the defendants, in which Semenov asked “Would you like to install KYC on tornado?” to which Storm responded, “I’m f___ing speechless / after such suggestions.”

Storm and Semenov also were allegedly aware that substantial proceeds from the massive and notorious Ronin Network hack, orchestrated by the Lazarus Group, were being transacted through Tornado Cash.  The indictment asserts that, reacting to media stories and inquiries, the defendants discussed changing the Tornado Cash user interface to supposedly block deposits from an OFAC-designated address, even though they knew that the change would be ineffective.  The indictment suggests this was done solely so that Storm and Semenov could issue a public statement that Tornado Cash was purportedly compliant with the law, while continuing to allow and profit from funds originating from designated addresses.

As noted, the indictment charges Storm and Semenov with operating an unlicensed money transmitting business.  FinCEN’s regulations define the term “money transmitter” as a person that provides money transmission services, or any other person engaged in the transfer of funds. The term “money transmission services” is defined further as “the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.” 

If this case proceeds to trial, whether Tornado Cash qualifies as a “money transmitter” under the BSA will surely be contested. In 2019 FinCEN, released its Virtual Currency Guidance.  Condensing greatly, the Guidance provides in part that whether a person or entity is a money transmitter turns on the issue of “control,” and that control of private keys can be a determining factor.  It is therefore no coincidence that the indictment alleges that Storm and Semenov maintained initial control of the private keys for the smart contracts.  The Guidance also provides that “anonymizing services providers” are money transmitters, because “their businesses consist exclusively of providing secured money transmission.”  However, according to the Guidance,  an “anonymizing software provider” is not a money transmitter.  The Guidance attempts to explain the distinction, noting that suppliers of tools (communications, hardware, or software) that may be utilized in money transmission, like anonymizing software, are engaged in trade and not money transmission.”  This distinction seems slippery, and the government and Storm presumably will argue over which label applies.  The government presumably will stress that the defendants satisfy the definition of a money transmitter in part because they provided “services” in exchange for profit:  not through direct receipt of a fee for each transaction, per se, but rather by profiting over time through increases to the value of the TORN tokens which they held, and which generally increased in value through the steady and increased use of Tornado Cash to transfer digital assets.

Finally, the indictment alleges that “Venture Capital Fund-1” (“VCF1”) provided $900,000 in financing to an entity owned and controlled by the defendants, in exchange for a share of future profits from Tornado Cash.  According to the indictment, representatives of VCF1 discussed with the defendants and CC-1, through an encrypted app, the possibility of adopting certain KYC and AML compliance steps.  In a testament to understatement, one VCF1 representative allegedly wrote, “I just don’t know if anyone will actually want this.  Market need seems quite thin.”  To dissipate any confusion, he clarified “it would be unlikely that as a fund we’d use a ‘compliant mixer.’”  Whether the DOJ has or will turn its attentions to VCF1 is unknown. 

What Does All This Mean?

The civil and criminal cases have not resolved.  The civil plaintiffs presumably will appeal to the U.S. Court of Appeals for the Fifth Circuit, and Storm may proceed to trial.  Many potential issues will need to be resolved, and it is conceivable that different courts will issue different rulings which are in tension with one another, or potentially outright contradict each other.

As always, the actual facts will be very important.  The separate but related issues of whether Tornado Cash is a “person” subject to OFAC designation, and whether Tornado Cash was a “money transmitting business” subject to registration with FinCEN, have been the topic of much attention by the media and the digital assets industry.  Certainly, some persons are wondering currently if a court would consider them to be an “anonymizing service provider” subject to the BSA, or instead to be just an “anonymizing software provider.”

However, it is conceivable that the defendants could be convicted of money laundering conspiracy, regardless of how the above issues play out, based on factual allegations that they personally took steps which assisted in some way third-parties attempting to launder illicit funds, knowing that funds were “dirty.”  As this blog frequently observes, the broad federal criminal money laundering statutes typically cast a wider net than the BSA and its particular regulations.  Further, it is also conceivable that the government ultimately could prevail in one or both of these legal actions, but that a future case with different facts will test again the abstract question of whether the government can act directly against a technology that operates independently, in a vacuum. 

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