The U.S. Court of Appeals for the Fifth Circuit on November 26 overturned the sanctions imposed by OFAC on cryptocurrency mixer Tornado Cash. The decision is pretty well motivated - compared to the first instance, one can sense a deeper and clearer understanding of the project's structure and how the protocol works.
In addition, the court answered a number of important but controversial legal questions. From a legal point of view, this precedent will be of great importance.
Immutable smart contracts are not property
Central to the Tornado Cash case was the question of whether immutable smart contracts can be considered property or services. It generally determines whether IEEPA sanctions can be applied.
Legal theory defines property as an object that can be owned, controlled and disposed of, including by restricting access by third parties. The court held that immutable smart contracts do not meet these criteria because there is no single person who can modify them or prohibit others from using them. Even if they wanted to, the creators of the protocol cannot do so.
The situation is similar with services: a smart contract can be used to provide them, but it is not a service in itself. The court referred to the definition in the legal dictionary, according to which “a service is an intangible product in the form of human effort, such as labor, skill, or advice.” An immutable smart contract, on the other hand, does not involve the expenditure of human labor.
On this basis, the court held that Tornado Cash's “immutable smart contracts (lines of software code that provide privacy) are not ‘property.’”
A smart contract is not a contract
Smart contracts and legal contracts are different things.
The court made two arguments:
- A legal contract is an agreement between two or more parties. In the case of immutable contracts, there is no second party (counterparty) and there is simply no one to enter into a contract with.
- Elements such as an offer, acceptance and counter-satisfaction are necessary to enter into a legal contract. Even if the user makes an offer, there is no person on the side of the protocol who can accept it.
The court also compared immutable and mutable smart contracts. Although the latter can facilitate the conclusion of a contract between their operator and a third party, the smart contract itself is an instrument and is not considered a legal contract.
The analogy with a vending machine, which was cited by the court of first instance, was also criticized by the appeal. The essence of the analogy is that when a customer interacts with the vending machine, they are entering into a transaction with the person who installed it and loaded the goods into it, which is similar to the use of smart contracts in transactions with virtual assets.
The appellate court pointed out that even if Tornado Cash was like a vending machine at one point, it is no longer, because the contracts have finally become immutable and there is no one who has control over the protocol.
The conclusion here is this: code is not law. In order to give legal force and meaning to a code or smart contract, it must be combined with suitable legal instruments.
Cryptomixers are not criminal a priori
What I think was an important point was an interesting admission: cryptocurrency mixers and other anonymity solutions, including Tornado Cash, are widely used for legitimate purposes, such as protecting data privacy and one's own security. Consequently, sanctions against an entire sector of the crypto industry due to individual unscrupulous users could lead to the infringement of law-abiding citizens' rights and stifle innovation.
Conclusions
The decision represents an important victory for the industry and has huge implications for financial privacy as a whole. Essentially, it is established that technologies that provide anonymity cannot be sanctioned simply because a limited number of individuals use them for illegal purposes.
Regulators must prove a link between specific wrongdoing and the tool used, rather than generalizing privacy-enhancing technologies as a threat.
