Cryptic Claims: The Rise of Cryptocurrency Litigation

The booming cryptocurrency market has attracted all sorts of shenanigans. While regulators struggle with how to best bring about enforcement, cryptocurrency users are not waiting around. They are suing. Cryptocurrency users are exercising their rights under existing federal, state and contract laws to recover damages. They can do this because much of the malfeasance in cryptocurrency markets is not novel, just repackaged.

Private litigation, enforcement by people rather than regulators, has thus far addressed three general issues in blockchain breakdowns: (i) “traditional” securities fraud; (ii) initial coin offering (ICO) failures; and (iii) platform disruptions. A summary of each issue is below, followed by some thoughts on what we might see next on the private litigation horizon.

Traditional Securities Fraud Litigation
Several publicly traded companies have recently ventured into the cryptocurrency markets. Observers described these companies as riding the blockchain wave, which boosted their stock prices. Riot Blockchain, Inc. (NASDAQ:RIOT), for example, changed overnight from a biotech to a blockchain investor. The company claims to have purchased thousands of bitcoin mining machines, invested in other companies that make blockchain applications, and intends to pursue launching a digital currency exchange in the U.S. Riot Blockchain’s stock price increased nearly 500% before allegations of insider trading, self-dealing and securities violations sent it sliding down.

While Riot Blockchain’s operations may be in new territory, there is a road map for aggrieved investors of publicly traded companies. Riot Blockchain is subject to tried and true federal securities laws. Investors can, and have filed, securities fraud claims like they would against any other public company. Investors in this situation often file a class action alleging the company made false and misleading statements that artificially inflated the stock price. When the truth of these statements became known, it caused the stock price to decline, damaging investors. The money lost in connection with the fraud is the amount investors typically claim for a recovery.

Initial Coin Offering Failures
It has been estimated that blockchain startups raised more than $5 billion through ICOs in 2017. And this year may well be another banner year for ICOs. While the momentum is exciting, many of these ICOs flop as fast as they take flight. Common problems include failing to launch, not delivering on business promises and mismanagement, if not outright theft, of raised capital. Although ICO failures are rampant and need curtailing, nearly all ICO organizers have taken the position that their offering is not an offering of securities. Ergo, they do fall not under the jurisdiction of securities laws or regulators. Moreover, many coin companies operate as if they are not subject to the authority of any regulators.

The reality is that many digital coins and tokens issued in offerings meet the definition of a security and should be regulated as such. Accordingly, as securities offerings, investors may be able to seek redress for ICO failures under securities laws. The Securities & Exchange Commission (SEC), for example, generally asks whether a transaction is: (i) an investment of money; (ii) with the expectation of profits; (iii) in a common enterprise; and (iv) with profits derived from the efforts of others. If so, then the SEC will likely take the position that the investment contract is a security subject to registration requirements.

In the same way, private litigation may be initiated against companies that failed to register their ICO as a securities offering. The lawsuit takes a three-step approach, alleging: (i) the cryptocurrency is a security; (ii) the company failed to register the security; and (iii) under securities laws, investors demand back their initial investment. This type of rescission claim was recently filed against Paragon Coin, Inc. In the fall of 2017, Paragon raised an estimated $70 million for its tokens. Paragon allegedly marketed its tokens to “investors” as appreciating in value against other cryptocurrencies and a good long-term investment. Insiders are also accused of misusing the raised capital. As a result, the price of Paragon tokens has decreased substantially. The ultimate goal of the lawsuit is for Paragon to give ICO investors their money back.

A caveat to consider is that there have yet to be any official court or government rulings declaring all ICOs as securities offerings. This could make some ICO claims more difficult to resolve. Moreover, the Commodity Future Trading Commission (CFTC) takes the position that cryptocurrencies are commodities. And the CFTC was recently successful in getting a federal judge to agree virtual currencies can be regulated by the CFTC as a commodity. Not to mention that some legislators are looking at defining cryptocurrencies as an entirely new asset class.

Platform Disruptions
Cryptocurrency is often traded on platforms (or exchanges) that purport to offer secure transactions and the safe keeping of digital wallets. Trades are routinely executed without issue. But all too often the system breaks down. Cybersecurity breaches from hackers (or insiders) continues to be a risk for users. Other issues have involved account freezes and trade halts—essentially the platform operator putting its interests ahead of the customer. These security and integrity issues are often covered by contract law. As such, the contract may determine if, how and in what circumstances a user may sue.

Last year, for example, the bitcoin exchange Kraken, experienced a distributed denial of service (DDoS) attack. This caused Kraken’s website to crash and customers were locked out of their accounts. At the same time, the price of cryptocurrency ether fell more than 70%. Kraken allegedly liquidated its captive traders’ leveraged positions and then refused to offer these customers any compensation. Kraken users initially filed a class action against the company for fraud, false advertising, negligence, breach of contract and unjust enrichment. Among other things, investors want to be compensated for sustained losses while locked out of their accounts. But lawsuits like this may need to confront arbitration clauses in customer contracts before determining the best path forward. For example, it appears the Kraken matter has shifted from a class action to being prosecuted as a group claim arbitration for specific customers. However, a class action may still be possible for other platform disruptions depending on the circumstances.

Private Litigation That (Possibly) Lies Ahead
While cryptocurrency has yet to achieve standardization, demand has already surged for cryptocurrency linked products. Many investors want cryptocurrency exchange traded funds (ETFs) and derivatives. To date, the SEC has denied any attempts to offer ETFs. If and when regulators allow cryptocurrency ETFs, one initial area of concern will be how and to whom the products are marketed. Investors should not be sold products that are unsuitable.

As for cryptocurrency derivatives, late last year, U.S. regulators approved trading of bitcoin derivatives on the Chicago Mercantile Exchange (CME) and the Chicago Board Options Futures Exchange (CBOE). And the CBOE has recently hinted at allowing derivatives of additional cryptocurrencies in the future. Like other derivatives, there is always the chance for market manipulation through collusion or other rogue trading. Antitrust laws may be available to provide remedies for traders should such a problem occur.

A Word of Caution
This post assumes the entities discussed are based in the U.S. Should a cryptocurrency user be wronged by a foreign company, there may be no remedy at all. The user would need to consult with a lawyer of that jurisdiction. And in any event, please consult with an attorney about your unique situation before making any decision. This post should not be interpreted as offering as specific legal advice. Even though, some jurisdictions may interpret this article as attorney advertising.

About the Author
David P. Abel is the Managing Attorney of USMA Law Group. His firm is a national law firm based in the District of Columbia. USMA Law Group represents investors in antitrust, securities and shareholder litigation. Mr. Abel is available to discuss with investors their concerns over possible misconduct by companies engaged in cryptocurrency and blockchain activities. You may email or call him to discuss your situation at no obligation or cost: dabel@usmarketlaw.com, 202-274-2037.

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