A New York judge will likely soon face some of the thorniest questions for regulators trying to police the cryptocurrency market.

Richard Heart, who founded and marketed the Hex crypto token, is accused by the Securities and Exchange Commission for selling unregistered securities and illegally using investor funds to purchase luxury goods, including a $1.38 million Rolex watch and a 555-carat black diamond known as “The Enigma.” Heart asks a federal judge to dismiss the SEC’s case.

The case is a testament to law enforcement’s reach in policing crypto transactions without borders. It also highlights questions about liability and who — or what — can be named as a defendant as the U.S. government cracks down on decentralized financial platforms and as currencies like Bitcoin surge once again in exchanges.

The SEC has appointed itself as the “global governor of blockchain technology,” lawyers for Heart, who lives in Finland, said in an April court filing archiving. The SEC’s response is expected in the coming weeks.

Cryptocurrency 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 lawsuit and what implications it could have going forward. In a statement last month, they argued that these are technological innovations that cannot be sued.

Legal scholars agree that the SEC’s approach appears novel.

“This is a case where technology is moving faster than the law,” said Michele Neitz, a professor at the University of San Francisco School of Law and founder of the Blockchain Law for Social Good Center.

“You can’t report the sidewalk”

Financial regulators have increasingly focus your eyes on decentralized finance, or DeFi.

The Commodity Futures Trading Commission carried enforcement actions in September against three DeFi companies and signaled that more may be coming. The SEC is too investigating Uniswap, the creator of the largest DeFi trading platform on Ethereum, for securities law violations.

The nature of the technology poses complex questions for regulators. The SEC supports Hex, which trades at a fraction of 1 cent, it is both a security and an entity. Heart and Crypto users dispute both interpretations.

“The fact that it can be a security, a currency and then an entity is largely because it becomes confusing and difficult to understand,” said Carliss Chatman, of Southern Methodist University. Dedman School of Law professor who teaches commercial and corporate law.

The SEC also named as defendants, along with Heart and Hex, the blockchain network PulseChain and PulseX, a decentralized financial platform. The SEC alleges that 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 briefwritten by Kayvan Sadeghi, partner at Jenner & Block LLP, and Nick Morgan, former SEC attorney and founder of Investor Choice Advocates Network.

“Nightmare Scenario”

The SEC’s reasons for including the token and network as defendants are unclear. But users fear this is an attempt to effectively shut down PulseChain and Hex, which have amassed significant followings.

Some blockchain lawyers say the agency’s approach could open the door to developers being held liable for the software they write. The SEC’s investigation into Uniswap has raised similar concerns.

Allowing the SEC to proceed with the case would create a “cloud of uncertainty as to what conduct may or may not be found to violate federal securities laws (and what inanimate technology could somehow be held responsible for any violation),” the users said . said briefly.

The SEC is not the first regulator to pursue what critics have called new and troubling topics in this area.

The CFTC in 2022 won a dominant 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 notified the DAO of the lawsuit by posting a copy of the complaint in an online chat and help forum, which various crypto groups said was improper.

In another case, a judge allowed cryptocurrency users to do so Sue a related DAO as a general partnership. The ruling put thousands of group members at risk of being held personally liable in the lawsuit, which the parties later settled.

These types of cases highlight lingering uncertainties about how new technologies fit into traditional legal concepts and the extent of potential legal risk for DeFi participants, lawyers say.

“I think the people who started cryptocurrency and DeFi were hoping for even more protection because there would be no entity,” said Stephen Rutenberg of Polsinelli PC, which focuses on cryptocurrency and blockchain technology.

“But the nightmare scenario,” Rutenberg said, “is that you also lose your corporate protection and you basically become a partnership where everyone is responsible for everything.”

Global reach of the SEC

Another issue in the case is whether Heart can be sued in the United States.

Those of the SEC cause v. Heart, filed last summer, was brought in the U.S. District Court for the Eastern District of New York. The SEC alleges that 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.

In filing his motion to dismiss, Heart said the court has no jurisdiction to hear the case.

The SEC did not say he has any offices or bank accounts in the United States or that he has visited the United States. Rather, the complaint affects an unknown number of US users, as well as YouTube videos and other social media posts.

“When will US courts have the ability to hear disputes involving these types of borderless transactions?” said Jonathan Schmalfeld, a Polsinelli lawyer who specializes in blockchain and other technologies. “Or in this case, the most appropriate court, whether it is a government body, private individuals or anyone else, would be Helsinki?”

Additionally, Heart said there are no types of U.S. securities transactions that would give the SEC authority.

The SEC complaint simply indicates that an “unidentified Brooklyn resident” and other unspecified U.S. investors sent crypto assets to a blockchain address associated with PulseChain, Heart said.

Citing an anonymous person in Brooklyn sending funds “is pretty crude compared to how you typically analyze whether the SEC has jurisdiction over a securities matter,” Schmalfeld said.

The case is Securities and Exchange Commission v. SchuelerEDNY, No. 23-cv-05749.

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