How the Binance Mothership Exerted Substantial Control Over its U.S. "Partner" from the Shadows

SEC v. Binance Court Filing, retrieved on June 5, 2023 is part of . You can jump to any part in this filing . This is part 25 of 69. HackerNoon’s Legal PDF Series here FACTS IV. ZHAO AND BINANCE ESTABLISHED THE BINANCE.US PLATFORM WHILE MAINTAINING SUBSTANTIAL INVOLVEMENT AND CONTROL OF ITS OPERATIONS. 154. Binance’s “partnership” with BAM Trading went beyond technology licensing. For example, during her tenure, BAM CEO A took direction from Zhao and Binance, and she referred to Binance as the “mothership.” BAM CEO A and other BAM Trading employees also provided weekly updates to Zhao and Binance concerning BAM Trading’s operations. 155. By July 2019, the Binance Consultant had crafted four purported “service-level agreements” between Binance and BAM Trading that governed their affiliation in operating the Binance.US Platform: a Master Services Agreement, a Wallet Custody Agreement, a Software License Agreement, and a Trademark Agreement (collectively, the “SLAs”). 156. But Zhao’s and Binance’s involvement in BAM Trading and the operation of the Binance.US Platform extended well beyond the SLAs. Consistent with the Tai Chi Plan, Zhao and Binance established a U.S. platform they controlled and that they would portray as “regulatory compliant” to divert regulatory attention away from Binance itself. Indeed, while Zhao and Binance were integrally involved in the operation of the Binance.US Platform from its inception, Zhao did not even execute the SLAs on Binance’s behalf until January 2020. i. Zhao and Binance Directed and Were Integrally Involved in the Operation of the Binance.US Platform’s Trading Services. 157. Binance—under Zhao’s control—was integrally involved in managing and operating the trading functions on the Binance.US Platform. As BAM Trading’s former Director of Operations testified under oath, Binance personnel were responsible for the Binance.US Platform’s matching engine, APIs, and market data systems. These Binance personnel “operated independently of” BAM Trading, such that BAM Trading only “would talk to [Binance personnel] when we [were] adding a new token [for trading on the Binance.US Platform] or when there was an upgrade or if a market maker had some issue with the API.” Zhao gave final signoff on various decisions relating to the Binance.US Platform’s trading services, including customer account opening processes, development of the front-end access, and creating a reserve to cover ACH deposits. 158. At least for a significant period of time after Binance.US launched, Binance held and controlled BAM Trading data offshore, and, at least through much of 2021, BAM Trading employees could not obtain certain real-time trading data for the Binance.US Platform without Zhao’s personal approval. 159. As BAM CEO A testified, there was “significant opacity” with respect to the Binance.US Platform’s trading data, and she “did not get answers from CZ on why or how or what we would need to do to be able to bring the data over” to the United States. She “wanted custody of the data and ability to interact with the raw data in real-time, as to my directions, not waiting on someone else’s approvals,” but she never received it. 160. Nor did the situation change when BAM CEO A’s successor (“BAM CEO B”) assumed the role in May 2021. BAM CEO B testified to SEC staff that the “level of … connection” between Binance and BAM Trading was a “problem” and that he had concluded that BAM Trading “need[ed] to migrate the technology to full [BAM Trading] control.” That transfer of control had not happened at least as of BAM CEO B’s resignation in August 2021. ii. Zhao and Binance Directed Selection of Crypto Assets for Trading on the Binance.US Platform. 161. Zhao directed which investment opportunities BAM Trading offered on the Binance.US Platform. For example, in September 2019, Zhao directed that the Binance.US Platform offer BNB for purchase and sale. Zhao and Binance knew that offering BNB on the Binance.US Platform created a significant risk that the SEC would take legal action against them, but they decided that the profit opportunity outweighed the risk. 162. In an internal chat in September 2019, the Binance CFO and the Binance CCO agreed that “CZ [wa]s willing to take the legal risk in listing BNB, if [they could] find a way to quantify it.” They further quantified the legal risk of listing BNB on the Binance.US Platform as “$10 mm in legal fees and settlements,” contrasted to the fact that BNB’s price could “go up 20%.” And, referring to the SEC’s June 2019 enforcement action in SEC v. Kik Interactive for the unregistered offer and sale of crypto assets as investment contracts under Howey, they noted that if a “Kik wells notice happens to BNB, BNB price can go down significantly.” The two also discussed that they would “start prepping everything” for a subpoena and Wells notice, including a “War chest.” 163. The Binance CFO then asked, “worst case scenario analysis for CZ? If he is ok with it and we are prepared to deal with it, then why not.” The Binance CCO replied, “This is the best approach, have him put rainy day analysis and have boss decide, though we are quite certain, he will push forward … Cutting US from .com already costed him an arm/leg, he’s not gonna hold back on getting that rev[enue] back somehow.” 164. Before the launch of the Binance.US Platform, BAM CEO A advised against offering BNB on the Binance.US Platform, but Zhao ultimately overruled her. As the Binance CCO later described, Zhao “brought [BAM CEO A] to the room to strongarm a [BNB] listing.” Pursuant to Zhao’s direction, BAM Trading offered BNB for offer and sale on the Binance.US Platform starting in September 2019. iii. Zhao and Binance Have Controlled BAM Trading’s Bank Accounts and Finances. 165. Until at least December 2020, BAM Trading personnel did not have any ability to control BAM Trading’s bank accounts, including accounts through which funds deposited by customers with the Binance.US Platform were held and transferred. 166. Instead, when BAM Trading opened bank accounts, Binance required that Zhao and/or the Binance Back Office Manager have signatory authority over the accounts. In November 2019, BAM CEO A raised questions about this directive with the Binance CFO, noting that having a “non-US resident non-employee on the bank applications … will be a red flag for regulators and will open .com to US scrutiny,” while also acknowledging “there is not that much separation internally” between Binance and BAM Trading. 167. Instead of giving BAM Trading personnel authority over BAM Trading’s bank accounts, Binance required BAM CEO A to come up with an alternative to allow Binance to maintain authority over the bank accounts without eliciting regulatory scrutiny. 168. In response, BAM CEO A proposed that “[w]e really only need [BAM Trading’s Finance Director] on client account as that’s the only account regulators will be looking at.” 169. As a result, until at least December 2020, the Binance Back Office Manager continued to be a signatory on BAM Trading’s bank accounts. And until at least July 2021, she was also a signatory on BAM Trading Trust Company B accounts that contained Binance.US Platform customers’ fiat deposits. 170. Zhao also controlled BAM Trading’s routine business expenditures and decisions. At least through January 30, 2020, Zhao’s approval was required for all BAM Trading expenditures exceeding $30,000. BAM Trading regularly sought approval from Zhao and Binance concerning routine business expenditures including rent, franchise taxes, legal expenses, Amazon Web Services (“AWS”) fees to host Binance.US Platform customer data, and even an $11,000 purchase of Binance-branded hooded sweatshirts. 171. Binance’s Shanghai-based finance team managed payment of BAM Trading’s expenses, including by executing money transfers between bank accounts and depositing cash injections from Merit Peak when BAM Trading operating funds were low. 172. Given its control over BAM Trading’s bank accounts, Binance’s finance team was also able to make substantial fund transfers without BAM Trading’s knowledge. For example, in June 2020, when Trust Company B alerted BAM CEO A that BAM Trading’s internal transfers had increased from approximately $10 million per day to $1.5 billion per day, BAM CEO A had no knowledge of such transfers, was unable to verify them because she lacked appropriate account access, and, as a result, had to ask Binance (a purportedly separate and distinct company) about the transfer of billions of dollars in BAM Trading’s own accounts. 173. Similarly, in December 2020, Binance transferred $17 million from BAM Trading’s bank accounts to Merit Peak. After learning of the transfer, BAM CEO A asked Binance employees about the transaction and eventually learned that the transfer related to Merit Peak’s trading on the Binance.US Platform. BAM CEO A responded, “thanks – helpful. Just had to get explanation anytime someone breaking our limits with massive withdraw[als] I have to ask – where you get that kind of money? And where is it going? . . . haha [I’m] on a wild goose chase to make sure we have knowledge of where $17M is moving around.” 174. Starting in or about December 2020, Binance permitted BAM Trading personnel to assume control over certain of BAM Trading’s bank accounts, but as of May 2023, Zhao still had signatory authority over BAM Trading’s account that held Binance.US Platform customers’ funds. iv. Zhao and Binance Controlled Binance.US Platform Customers’ Funds and Crypto Assets Deposited, Held, Traded, and/or Accrued on the Platform. 175. In addition to controlling BAM Trading bank accounts that held customer funds, at least through December 2022, Binance was the designated custodian for crypto assets deposited, held, traded, and/or accrued on the Binance.US Platform, as expressly recognized in the SLAs. Internal communications indicate that BAM Trading and Binance understood that “.com is the custodian .us uses” and “CZ control[s] the wallet.” Binance had sufficient control to manage and authorize the transfer of crypto assets, including between various omnibus wallets, without the need for any authorization from BAM Trading. During this time, BAM Trading employees had little or no oversight of, or insight into, Binance’s custody and control of these crypto assets, and almost all the employees working on clearing and settlement for spot trading on the Binance.US Platform were Binance employees located outside of the United States, primarily in Shanghai. 176. At least as of the beginning of June 2023, these crypto assets are not all within the exclusive custody and control of BAM Trading personnel within the United States. 177. This custody arrangement and lack of controls pose substantial risk to U.S. customers. Binance.US Platform customers have no agreement with either BAM Trading or Binance relating to the custody of crypto assets that they deposit and store through the Binance.US Platform. Customers are provided little, if any, information about the digital wallets where these crypto assets are held or about how their crypto assets are stored, secured, and transferred. Indeed, BAM Trading and Binance have not disclosed Binance’s responsibilities and ongoing involvement in the custody and control of these crypto assets or their participation in the Binance.US Platform’s staking-as-a-service program and custody and control of crypto assets that are staked or accrued as part of that investment program. 178. This arrangement has given and continues to give Zhao and Binance free reign to handle billions of dollars of crypto assets that customers have deposited, held, traded, and/or accrued on the Binance.US Platform with no oversight or controls to ensure that the assets are properly secured. 179. BAM Trading, Binance, and Zhao were well aware that Binance’s custody and control over fiat and crypto assets deposited, held, traded, and/or accrued on the Binance.US Platform created significant risks for Binance.US Platform investors. Indeed, in a May 2, 2020 letter to BAM Management’s board, the firm that audited BAM Trading’s financial statements (“Audit Firm”) identified for the company numerous internal control deficiencies, including the following: a. As to the “Safeguarding of Assets,” the Audit Firm “observed that [an employee] from Binance.com is the approver on [BAM Trading’s] bank account” and recommended “handing over this power to someone … at Binance.US.” b. As to “Digital Assets,” the Audit Firm found several deficiencies relating to Binance’s failure to provide information concerning its custody of crypto assets deposited and traded on the Binance.US Platform, including that it “was difficult and sometimes not possible to pull wallet balances en masse as of a historical point in time. This makes it very difficult to ensure the Company is full[y] collateralized at specific points in time.” It recommended that BAM Trading work with Binance “to provide the daily reconciliation and historical reporting functionality necessary for audit and operational purposes,” and “instituting a formal process to track crypto units held for each” crypto asset. c. The Audit Firm found “a lack of documented controls and overall transparency at the custodian [Binance]. Binance.us may not be aware of financial or operational risks that exist related to the custodian.” It recommended that the company document its controls to ensure that Binance’s processes “are functioning as intended and are reliable for operational and financial reporting purposes.” 180. The following year, the Audit Firm continued to identify significant weakness in controls with respect to custody of digital assets. On May 20, 2022—in its third letter identifying weakness for the company—the Audit Firm found that BAM Trading did “not have much visibility into on-chain activity related to it[]s exchange. The Company is dependent on the .COM custodian to tell them the addresses holding the assets, or other relevant metrics.” Similarly, the Audit Firm concluded that it “was difficult and sometimes not possible to pull wallet balances en masse as of a historical point in time. ” (Emphasis added.) This makes it very difficult to ensure the Company is fully collateralized at specific points in time. 181. That Audit Firm did not continue its engagement after November 2022. BAM’s new auditor stated in BAM Trading’s audited financials for the year ending December 31, 2022 that Binance remained the custodian of all of BAM Trading’s crypto assets, including crypto assets deposited, held, traded, and/or accrued by customers, until at least December 2022, when BAM Trading terminated the Wallet Custody Agreement. Even after that time, and as of at least June 3, 2023, Binance continues to participate in the custody and control of Binance.US Platform’s digital wallets and these crypto assets through the various services it provides to the Binance.US Platform and its possession, custody, and control of private keys or portions thereof (sometimes referred to as “key shards”) associated with the security access protocols that govern the digital wallets holding certain of these crypto assets, the authorization for transfers, and operations as part of the staking-as-a-service program. 182. BAM Trading did not even implement a formal policy concerning its crypto assets custody and operations until May 15, 2023. 183. As of the end of 2022, BAM Trading was responsible for over $1.77 billion of Binance.US Platform customers’ crypto assets. v. Zhao and Binance Directed BAM Trading to Engage Zhao-Controlled Market Makers on the Binance.US Platform. 184. To create and maintain liquidity on the Binance.US Platform, BAM Trading recruited market making firms and other institutions, often offering low fees as incentives. Zhao and Binance were intimately involved in these efforts, which placed Zhao’s financial interests at odds with those of the customers trading on the platform he controlled. 185. From the earliest days of the Binance.US Platform, Zhao directed BAM Trading to onboard two market makers that he owned and controlled: Sigma Chain and Merit Peak. Both entities were operated by several Binance employees who worked at Zhao’s direction, including the Binance Back Office Manager, who, at least until December 2020, also had signatory authority over BAM Trading’s U.S. Dollar accounts. 186. BAM Trading’s relationships with Sigma Chain and Merit Peak aligned with the Tai Chi Plan strategy to rely upon “trusted” market makers for the U.S.-based crypto platform. As Zhao characterized it, Sigma Chain needed to be a market maker on the Binance.US platform because it was Binance’s “own” market maker, compared to those an “arm[’s] length away.” 187. Merit Peak and Sigma Chain were active traders on the Binance.US Platform. Merit Peak traded on it at least from November 15, 2019 to June 10, 2021. Until at least April 2022, Sigma Chain was a frequent spot trader on the Binance.US Platform, and it also continues to serve as a counterparty for certain OTC trading, and the Convert and OCBS services on the Binance.US Platform. 188. Sigma Chain’s and Merit Peak’s activity on the Binance.US Platform, and their undisclosed relationship with Zhao and Binance, have involved and continue to present conflicts between Zhao’s financial interests and those of Binance.US Platform’s customers. 189. Indeed, BAM CEO B expressed concerns to Zhao about Merit Peak’s and Sigma Chain’s activity on the Binance.US Platform. As he testified under oath, “To the extent that these two liquidity providers were significant sources of liquidity, meaning that our customers couldn’t, you know, clear orders without the presence of those makers on our platform, I thought that was a real problem. It suggested that the company was, in fact, heavily dependent on CZ, not just as a control person but also as an economic counterparty and that is problematic, so I thought we needed to look into deplatforming them.” 190. BAM CEO B’s concerns were well founded. Merit Peak and Sigma Chain accounts were used in the transfer of tens of billions of U.S. dollars involving BAM Trading, Binance, and related entities. For example, by 2021, at least $145 million was transferred from BAM Trading to a Sigma Chain account, and another $45 million of funds were transferred from BAM Trading’s Trust Company B account to the Sigma Chain account. From this account, Sigma Chain spent $11 million to purchase a yacht. 191. Further, since the launch of the Binance.US Platform, Merit Peak’s U.S. bank account received, as a “pass through” account, over $20 billion that included customer funds from both Binance Platforms. Merit Peak then transferred the vast majority of those funds to Trust Company A, in transfers that appear to relate to the purchase of BUSD. As Merit Peak was a purportedly independent entity, sending Binance customer funds to Merit Peak placed those funds at risk, including of loss or theft, and was done without notice to customers. 192. In addition, Zhao’s contro l over both BAM Trading and Sigma Chain has enabled Sigma Chain to conduct the manipulative trading on the Binance.US Platform described below. Continue Reading . Here About HackerNoon Legal PDF Series: We bring you the most important technical and insightful public domain court case filings. This court case 1:23-cv-01599 retrieved on September 6, 2023, from is part of the public domain. 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