In a case challenging the sanctions levied against Tornado Cash in the U.S. District Court for the Western District of Texas, Judge Robert Pitman sided with the Department of Treasury. His Order entered on August 17, 2023, grants the Department of Treasury and OFAC's cross-motion for summary judgment, upholding the prohibition on American citizens' use of the Tornado Cash software.
This article summarizes the Court's ruling on novel issues debated by the Coinbase-funded plaintiffs and the U.S. government.
Background
Tornado Cash is a free software comprised of 20 Ethereum addresses that allows persons to anonymously transact tokens on the Ethereum blockchain. This is an important fact as the Court's decision turns on its understanding of whether Tornado cash is a "thing" or an "entity."
The Department of the Treasury added a Tornado Cash "person" to the Specially Designated Nationals List on August 8, 2022, listing several dozen Ethereum addresses, including immutable smart contracts that were allegedly tied to the Tornado Cash "person." This prohibited any person in the U.S. from sending funds to, or receiving funds from, these designated smart contracts. On September 8, 2022, a group of plaintiffs filed an action to challenge the designation of Tornado Cash on the ground that it exceeds the Department's statutory authority and was not in accordance with the law.
The Department added 53 Ethereum addresses to a new designation on November 8, 2022, 20 of which are immutable Tornado Cash pools that permit users to engage in transactions in various cryptocurrencies. In both designations, the Department asserted Tornado Cash is an entity comprised of three founders, other developers, and the Tornado Cash DAO, alleged to consist of all TORN token holders. The Department later published guidance1 that stated the designation of Tornado Cash does not include "Tornado Cash's individual founders, developers, members of the DAO, or users, or other persons involved in supporting Tornado Cash."
The case deals with two statutes, the International Emergency Economic Powers Act (IEEPA), which permits the Department of the Treasury to take certain actions with respect to "any property in which any foreign country or a national thereof has any interest,"2 and the North Korea Sanctions and Policy Enhancement Act of 2016, which authorizes the Department to "block and prohibit all transactions in property and interests in property of a person designated" for engaging in certain activities involving North Korea.3
The Plaintiffs asserted two primary arguments: the Department does not have the authority to designate Tornado Cash and even if it does have such authority, such designation violates the First Amendment.
The designation of Tornado Cash is contrary to law and exceeds the Department's statutory authority.
- Tornado Cash is not a foreign national or person.
This argument boils down to the Department being authorized to take actions with respect to property and transactions of foreign nationals and persons engaged in certain conduct, not smart contracts.
Plaintiffs argued the plain meanings of "national" and "person" do not contemplate the Tornado Cash smart contracts. They also argued no formal entity exists, and the Department failed to establish that Tornado Cash founders and developers, with the holders of TORN, formed an unincorporated association by manifesting an agreement to cooperate in the furtherance of a common purpose.
The Court rejected the argument that Tornado Cash is merely autonomous software and held it may be properly designated as a person because it is an "association" under that terms dictionary meaning, which is "a body of persons who have combined to execute common purpose or advance a common cause." The Court found "[s]ubstantial evidence supports the argument that founders, developers, and the DAO constitutes '[a] body of persons who have combined to execute [the] common purpose" of developing, promoting, and governing Tornado Cash.'"
Plaintiffs' also argued unsuccessfully that OFAC did not identify an entity because the Tornado Cash founders, developers, and DAO members did not manifest any agreement to a common purpose. In rejecting this argument, the Court determined that merely by being voting members, DAO members demonstrated an agreement to a common purpose.
The Court also rejected Plaintiff's third argument that Tornado Cash cannot be an association because OFAC merely designated the protocol's founders, developers, or DAO members as a group without designating such persons individually. The Court determined this approach was not inconsistent with OFAC's authority, comparing it to sanctioning a company without sanctioning its individual officers.
- The immutable smart contracts are not property.
Plaintiffs argued the Tornado Cash smart contracts are not "property" because they are immutable, and something that cannot be controlled, deleted, or changed is incapable of being owned. Since the Department can only regulate "property" under the relevant statutes, it does not have the authority to regulate the smart contracts at issue.
The legal standard and defined terms applicable in this case created a significant barrier for Plaintiffs to overcome. To prevail on its argument that smart contracts are not property, Plaintiffs were required to show the Tornado Cash smart contracts are "plainly inconsistent" with the expansive regulatory definition of that term, defined as "contracts of any nature whatsoever."
The Court determined that OFAC's definition sufficiently covered the Tornado Cash smart contracts because the record showed "Tornado Cash promoted and advertised the contracts and its abilities and published the code with the intention of people using it—hallmarks of a unilateral offer to provide services."
- The purported Tornado Cash person does not have an "interest in property" in the smart contracts.
Plaintiffs' also argued OFAC's designation of Tornado Cash is improper because the Department's authority to regulate an "interest in property" does not extend to the ownerless smart contracts. The appropriate definition of an "interest in property" is a "legal or equitable claim to or right in property," argued Plaintiffs. The Court refused Plaintiff's narrow definition, instead opting for OFAC's expansive definition of "interest," which includes "an interest of any nature whatsoever, direct or indirect."
Considering OFAC's expansive definition of "interest," the Court determined Tornado Cash had a beneficial interest in the deployed smart contracts. It reasoned the smart contracts provided Tornado Cash with a means to control and use the TORN tokens, which created a regular stream of revenue for Tornado Cash. The fees generated by the smart contracts constituted an ongoing benefit in which Tornado Cash had a property interest, according to the Court.
The Department's action violates the Free Speech Clause of the First Amendment because: (a) The Department's action is not narrowly tailored to address a compelling interest; and (b) the Department's action is unconstitutionally overbroad.
The Plaintiff's also objected to OFAC's designation of the Tornado Cash smart contracts on First Amendment grounds, arguing that even if the Department could regulate the smart contracts, its designation is too broad in violation of the Free Speech Clause of the First Amendment. The Court was not persuaded. It delineated the right to publish source code and the right to interact with the source code as two distinct rights. OFAC's designation blocked the right to transact using the source code and not the right to publish it. Ultimately, the Court ruled that Plaintiffs failed to demonstrate the designation had a chilling effect on the freedom to publish or use (in ways other than transacting with) the source code for the Tornado Cash protocol.
Conclusion
The Court ruled in favor of the Department's cross-motion for summary judgment on all claims, upholding a ban on the use of the Tornado Cash protocol by American citizens.
Takeaways
The decision is another impactful one for the DeFi space and developers. It is important for several reasons, one of which is the manner in which the Court addresses the concept of "control" over smart contracts by a DAO.
Like the Ooki DAO case, this case addressed the issues of technology versus legal personhood and the bounds of the definition of an unincorporated association as applied to token holders. Importantly, Judge Pitman's found the Tornado Cash "entity" had a beneficial interest in the smart contracts because of its control over the TOR tokens.
The Court's comparison of TORN token holders to stockholders in a corporation is also concerning. While a helpful analogy in offering a layman's explanation of a DAO, this example is lacking as support for finding a common purpose exists among an entire group of token holders. Unlike stockholders, who have a common purpose of excising value from a company's stock, a token holder in a DAO may have very different uses for holding the Tokens. Indeed, TORN token holders may transfer their holdings on the Ethereum blockchain without ever interacting with the Tornado Cash protocol. If mutual assent to pursue a common interest is a prerequisite to finding a group of persons to form an unincorporated association, then it would follow that the governance token holders who vote against or in favor of passing a particular proposal could be considered an unincorporated association. But OFAC and the Court failed to make this important distinction. If you zoom out far enough, you can always find a common purpose.
Footnotes
1 OFAC, Frequently Asked Questions (Nov. 8, 2022) < tinyurl.com/OFAC-FAQ-1095 > (FAQ 1095).
2 50 U.S.C. § 1702(a)(1)
3 22 U.S.C. § 9214(a), (c) (emphasis added).
Originally published by 23 August 2023
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