Litigation Updates — August and September 2018
For our August and September regulatory and compliance updates, we are going to post separately about various subtopics. This first post on litigation will review several court cases that relate to blockchain and cryptocurrency.
Ripple
Ripple continues to face a number of lawsuits from various parties for alleged violations of securities laws. While this legal battle is expected to continue for some time, Ripple scored a tactical win August 30th by convincing a court that a California lawsuit should be combined with other cases, limiting the number of forums that Ripple will be required to contest.
In addition, one of the class-action lawsuits in federal court was voluntarily dismissed after Ripple successfully fought off efforts to move the case to a state court.
On September 11, Ripple reportedly settled with R3, which had filed a lawsuit claiming that Ripple had not honored an agreement that gave R3 the option to purchase 5 billion XRP tokens. The option would have given R3 the ability to purchase the XRP tokens for a price of $0.0085 per token; at the time of the settlement, XRP was trading at $0.26. In turn, Ripple alleged that R3 did not honor its end of a joint commercial venture the two companies had initiated. Terms of the settlement were not disclosed.
Tezos
In another California case affecting a major ICO, plaintiffs in four class action lawsuits against Tezos — and its founders — successfully defeated a motion to dismiss the part of the case that was against the founders and their affiliated companies. The founders had sought to argue that the case should be thrown out because the ICO was launched through a Swiss foundation, not their US-based company. The court ruled, among other things, that the US company and the Swiss foundation were “deeply intertwined, if not functionally interchangeable throughout the ICO process” and that the website that facilitated the ICO was primarily managed in California. This decision indicates that efforts by ICO issuers to avoid liability by structuring their companies in foreign jurisdictions may not be successful in court if the activities of different companies are not sufficiently separated. (link)
Crypto Bail
We have previously discussed the growing trend of law enforcement agencies seizing cryptocurrencies during criminal investigations, and, in some cases, auctioning the seized cryptocurrency. On August 15, 2018, a California court found a new use for cryptocurrency as part of the litigation process, requiring a defendant to pay bail in the form of bitcoin or any other cryptocurrency. The defendant, a resident of Italy, allegedly hacked into the gaming company Electronic Arts and stole account information for 25,000 users.
AT&T
The crypto world has seen numerous lawsuits in which holders seek to recover funds that were lost in hacks. Typically, these lawsuits are against the crypto exchanges or the ICO issuer. On August 15, a plaintiff took a new approach, suing AT&T for actions that allegedly resulted in a theft of $24 million in cryptocurrencies by hackers. According to the compliant, the hackers were able to access and steal cryptocurrency holdings by taking control of the victim’s cell phone account, with the help of AT&T insiders who did not check the hacker’s id or requiring him to provide a password. The plaintiff is also seeking $200 million in punitive damages. AT&T disputes the charges.
Mt. Gox
In a case taking a different direction, investors who held their cryptocurrencies in the defunct Mt. Gox exchange filed a case in an Illionois court against Mark Karpeles, the founder of Mt. Gox, in his personal capacity. After its infamous 2014 hack, the exchange went bankrupt and began accepting claims from creditors as part of the proceedings in August. The plaintiffs in the case against Karpeles are seeking to go beyond the bankruptcy process and recoup their alleged losses from the collapse and bankruptcy from Karpeles’ personal funds, on the claim that these losses resulted from his individual fraud. Karpeles filed a motion to dismiss, claiming that as a French citizen residing in Japan, the Illinois courts do not have jurisdiction over his activities.
Monkey Capital
In Florida, plaintiffs suing the companies and founder behind the Monkey Capital ICO (which apparently never actually happened) won an easy victory in the portion of their case against the companies, when they were awarded a default judgement because the companies did not provide a response to the lawsuit or hire lawyers to represent them. After emailing the judge to accuse the court of racism, harassment and corruption, the individual founder Daniel Harrison (who refers to himself as the founder of DMH&CO) did provide a response, representing himself, and that part of the case is still ongoing. The plaintiffs claim that, among other things, the defendants took their investment amounts and then allocated all of the tokens to the founder rather than consummating the ICO. The defendant allegedly then converted all of the tokens to other cryptocurrencies valued at $30 million (in early 2018).
Unikoin
Plaintiffs who invested in the Unikoin ICO, which was backed by shark tank host and NBA owner Mark Cuban and other celebrities, filed a lawsuit against the company and team behind it for selling them unregistered securities. The price of the token fell from $0.30 at the ICO to $0.055 as of the time of the complaint.
Unlike most other lawsuits we have seen regarding ICOs, the plaintiffs in the Unikoin ICO made their claims solely based on the sale of unregistered securities, which means they can rely on a theory of strict liability and do not need to allege fraud or other bad intent. One point to watch is that the plaintiffs used the fact that the defendants filed a Form D registering the SAFT agreements (which are a separate contract granting the future right to receive tokens in the ICO) with the SEC as part of their argument that the tokens themselves were securities.
Typically, the intent of a SAFT structure is that the agreement to sell future tokens is admittedly a security, which is only sold to accredited investors under Regulation D, but the tokens that will be separately issued under the SAFT are a separate instrument that is classified as a utility that is not a security. It will be key to see if the defense is able to convince the court that this SAFT structure is sufficient to deflect this argument.
CFTC v. McDonnell
One important case that has been working its way through the federal courts in the Eastern District of New York in New York, and appears to now be complete, is CFTC vs. McDonnell. The main defendant, Patrick McDonnell, operated a company called CabbageTech Corp. (d/b/a coin Drop Markets), and was accused by the Commodities and Exchange Commission (“CFTC”) of engaging in manipulative and fraudulent activities. The defendant had decided not to retain counsel, represented himself and did not always appear in court on schedule.
The CFTC claimed that the defendant engaged in a “boiler room” scheme, where customers were convinced that they were receiving bona fide investment advice regarding virtual currencies, and that the defendants were making trades of virtual currencies for the customers. According to the CFTC, the defendant did not engage in these activities and instead simply stole the investor’s funds and used fake employee names, Wall Street addresses and corporate titles to convince them he was engaged in a legitimate business.
The key issue in the early part of the trial was McDonnell’s challenge to the CFTC’s authority to prosecute him, on the theory that virtual currencies are not a commodity. Under the Commodities Exchange Act (“CEA”), the CFTC has general authority to monitor and prosecute fraud in a list of items, which includes the catch-all categories “all other goods and articles… and all services, rights and interests.” However, one requirement is that the list only covers goods “in which contracts for future delivery are presently or in the future dealt in.” The CFTC has argued that bitcoin and other virtual currencies are covered by the definition in several of its agency rulings and pronouncements.
In July, the CFTC won the case against McDonnell when he stopped coming to court during the trial. As result, he automatically los the case and the judge awarded a default judgement and required him to pay $290,0429 in restitution and $871,287 in penalties. However, in its decision, the court rejected the defendant’s argument that virtual currencies are not commodities under the CEA’s definition and accepted the CFTC’s interpretation of the law. Interestingly, in addition to the CFTC’s arguments, the court also cited an amicus brief that was submitted by the Chicago Mercantile Exchange (CME), a large derivatives marketplace that facilitates the trade of bitcoin futures. The CME argued that virtual currencies are commodities, supporting the CFTC, and also said that a decision holding that cryptocurrencies are not regulated by the CFTC would damage the CME and its market participants who rely on the CFTC to prevent fraud and manipulation. The CME’s involvement in the case, arguing in favor of cryptocurrencies being subject to the CFTC’s regulation, indicates that large mainstream institutions are more likely to encourage additional regulation than others in the crypto space, and that the institutional views are likely to carry significant weight with courts and other authorities.
However, the decision did leave some open questions. While the CEA says that the CFTC’s jurisdiction only covers commodities for which future contracts are “dealt in”, the court never expressly explained how other virtual currencies besides bitcoin, that do not currently have a futures market, fall under the CEA’s definition.
On August 23, the CFTC won an additional round when the court issued a permanent trading and registration ban against the defendant. The injunction against the defendants prevents them from doing a variety of activities, including trading on or subject to the rules of any registered entity, entering into any transactions involving commodity interest, having any commodity interests or virtual currencies traded on their behalf, controlling trading on behalf of any other person, receiving funds for such sales, or applying for registration or claiming exemption from registration and engaging in any activity requiring such registration or exemption.
CFTC vs. My Big Coin Pay, Inc.
On September 11, the CFTC achieved success in a similar case in Massachusetts, CFTC vs. My Big Coin Pay, Inc. The CFTC charged the defendants in that case with carrying out a fraudulent scheme regarding virtual currency. According to the CFTC, the defendants offered the sale of a fully functioning virtual currency called My Big Coin, but did so by making false statements. These false statements included claims that the coin was backed by gold, could be used wherever Mastercard is accepted, and was being actively traded on exchanges. They also allegedly made up trading prices. Victims could view their outstanding balances but could not trade their tokens or withdraw funds. The defendants acquired $6 million from these activities.
The defendants brought a motion to dismiss the case before trial, arguing that the CFTC did not have jurisdiction because the My Big Coin was not a commodity within the meaning of the CEA, and even if it was, the CFTC only has jurisdiction over certain types of market manipulation and not the type of fraud that was alleged.
On the first point, the defendants brought a similar argument to the defendant in McDonnell — claiming that because “contracts for future delivery” are not dealt in My Big Coin, they cannot be a commodity under the CEA. In this case, unlike McDonnell, the CFTC and the court addressed the question of whether virtual currencies fit the definition of “commodity” under the CEA even if there is no live futures contract for that specific virtual currency. The CFTC argued expressly that contracts for future delivery of some virtual currencies are currently dealt in on various markets(such as the bitcoin futures contracts), and that therefore all virtual currencies are commodities because they fit into a general category of items in which contracts for future delivery are sold.
The court sided with the CFTC, noting among other things that the CEA classifies “livestock” as a commodity generally without listing which species are included. The court took this and other similar examples as evidence that the statute refers to categories and there is no requirement that a futures contract actually exist for the specific item in question.
Regarding the second question, the court cited the language of the statute that prohibits any “manipulative or deceptive device or contrivance” in selling commodities. According to the decision, the fact that the law specifically adds “deceptive” in addition to “manipulative” devices was meant to include actions like those alleged here that operate as fraud or deceit, not just market manipulation.
This case adds to the growing body of decisions supporting the idea that the CFTC has the right to go after all fraudulent sales of virtual currencies, even those that do not underlie any of the derivative contracts regulated by the CFTC.
USA v. Zaslavskiy
Back in May, we wrote about the case of USA v. Zaslavskiy, which has proceeded in the federal courts in the Eastern District of New York. There is both a civil case brought by the SEC and a criminal case brought by the Department of Justice (DOJ). The defendant in the case was accused of running two fraudulent ICOs, ReCoin and DRC. He allegedly claimed that the tokens were uniquely backed by real assets (real estate in one ICO and diamonds in the second) and would be usable on an accessible platform, while in fact no coins or platform were developed at all.
In his response to the case, the defendant sought to dismiss the case for two reasons — one, because the tokens he was selling were not securities and two, because the lack of clarity about whether the securities laws apply to virtual currency tokens renders these laws unconstitutionally vague as applied. The SEC and the DOJ vigorously contested the motion to dismiss, arguing that the tokens were in fact securities under the famous Howey Test and that the laws are not vague, in part because the SEC had given clarity to these rules in its guidance, such as the DAO Report issued in July 2017.
On September 11 — ironically one year after announcing the DRC ICO — the court decided in favor of the government. On the question of constitutionality, the court argued that, if the “21st century jargon” is removed, the allegations described a standard type of financial fraud, in which the defendant made false statements to induce potential investors to give up their resources in the hope of financial gain. Furthermore, the fact that the securities laws use a broad and flexible definition to effect their purposes, as well as the body of information interpreting the Howey Test, also should have been known to the defendant and would have provided sufficient clarity to meet constitutional requirements. While the facts of the case would still need to be proven at trial, the law that prohibits the fraudulent sale of investment contracts is not constitutionally vague.
On the “securities” definition, the court found that a reasonably jury could find that the tokens offered were securities under the Howey test, which defines a transaction as an “investment contract” if it meets the elements of (i) an investment of money; (ii) in a common enterprise and (iii) an expectation of profits solely from the efforts of others. The court found that the token purchasers did make an investment of money, and rejected the defendant’s argument that they were merely exchanging one form of currency to another. Among other things, the court relied on previous cases that found that the purchase of rare coins counted as an investment when they were advertised as such. The court also noted that the ICOs offered “membership” in the in the ventures, so were not only an exchange of currencies.
The court also found that a reasonable jury could find that the investment was a common enterprise because the investors received tokens in proportion to their investment. The court found that the third prong of expectation of profits could be established by various statements made by the defendant that claimed that there would be financial returns on the investment. In addition, the court noted statements that advertised that skilled professionals would use their expertise to develop the venture. As a result, the motion to dismiss failed and the case will proceed to trial.
Note that this is still a relatively early part of the case, and for purposes of this ruling, the court assumes that all of the facts claimed by the government in the indictment are true. The defendant could still prevail if he can challenge the government’s factual claims at trial.
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