Cryptocurrency companies face a steadily growing number of lawsuits, adding to a list of recent headaches for their industry. That list includes steep recent declines in investment value and a high probability of new government regulations in the near future.
Investor losses have led to a surge of new class actions and other suits filed against issuers, platforms, managers and even celebrity promoters.[1]
Many of the cases allege pump-and-dump schemes, in which company officials essentially artificially inflate their company's market value, then cash out and leave investors holding the bag as prices plummet.
Others assert that the cryptocurrency issuers misled investors in other ways, such as through deceptive marketing. Still others involve claims that the company's digital tokens are unregistered securities and violate Title 15 of the U.S. Code, Section 77e(c) — part of the Securities Act.
Many suits targeting crypto companies, or individuals associated with them, have either been dismissed on procedural grounds, voluntarily dismissed by the plaintiffs or settled in private. As a consequence, assessing the likelihood of success of pending or future claims of these types is extremely difficult.
What is clear, though, is that all of those categories of claims, and others, are ones to which the crypto industry has significant potential vulnerability. Here is a more detailed overview of the types of assertions and arguments most commonly being made by plaintiffs thus far, and the counterarguments made by crypto companies and their managers and promoters.
Securities Act Violations
Several suits claim that crypto companies are issuing and selling unregistered securities in violation of the Securities Act. A crypto asset will likely be considered a security if it satisfies the four-prong Howey test. That test, named after the highly influential 1946 U.S. Supreme Court case U.S. Securities and Exchange Commission v. W.J. Howey Co., requires that:
1. A party must make an investment of money or other valuable consideration;
2. The investment must be in a "common enterprise";
3. Investors must have a "reasonable expectation of profit"; and
4. The profits are expected to be "derived from the efforts of others."
Some federal courts have ruled that, in certain circumstances, cryptocurrencies may be subject to federal securities laws.[2] In response to these claims, defendant crypto platforms, like Coinbase Global Inc., have argued that even if crypto is a security — as opposed to a commodity or something else — it is not being bought or sold by the platform but, rather, the platform is the intermediary that matches users and earns fees from user transactions.
Another crypto platform, Binance Holdings Ltd., successfully argued that because it was a foreign entity, federal securities laws were inapplicable to it.
A case that highlights the complex and fact-intensive nature of cryptocurrency classification is the class action Audet v. Fraser in the U.S. District Court for the District of Connecticut. The jury in that case concluded in November 2021 that none of the crypto products purchased by the class were securities under the Howey test.
But, upon consideration of the plaintiff's post-verdict motions, on June 3 the court rejected the jury's finding that one product, Paycoin, was not an investment contract and ordered a new trial to determine the classification of Paycoin.
In addition to private suits, crypto companies are currently facing suits brought by regulatory agencies, like the SEC, for failure to register securities in violation of the Securities Act.
One such suit is SEC v. Ripple Labs Inc. in the U.S. District Court for the Southern District of New York, which could have enormous consequences for the crypto industry because, if Ripple loses, many tokens trading on platforms in the U.S. would be required to register with the SEC.
As of now, the judge hearing that case has denied Ripple's motion to dismiss but has also declined the SEC's request to strike Ripple's affirmative defense that it was never given fair notice by the agency that the token sales violated securities laws.
Fraud
Many suits involving the crypto industry involve claims of fraud, misrepresentation, and/or that the crypto companies, or the individuals associated with them, engaged in pump-and-dump schemes.
For example, in In Re: EthereumMax Investor Litigation, investors have accused celebrities like Kim Kardashian and Floyd Mayweather of promoting on social media what many have alleged was a classic pump-and-dump scam.
The plaintiffs claim the defendants knowingly and falsely — through allegedly misleading, inaccurate statements — pumped up the price of the token, then sold their holdings and left other investors to suffer the losses when the value of the token depreciated over 70% from its all-time high.
In De Ford v. Koutoulas, the U.S. District Court for the Middle District of Florida recently dismissed without prejudice a putative class action filed by buyers of the "Let's Go Brandon" meme tokens who sued LGBcoin and NASCAR driver Brandon Brown for fraud. Like the EthereumMax case, investors in the "Let's Go Brandon" token alleged that the crypto company and the celebrity driver knowingly engaged in a scheme to launch a cryptocurrency that would reach an inflated value and then crash when the true facts about it came to light.
The case was dismissed July 11 as a shotgun pleading, which is essentially a complaint that is too vague to give the defendant fair notice of the claims being pursued. Given that the dismissal was without prejudice, the plaintiffs now have an opportunity to attempt to replead their claims.
Plaintiffs in the U.S. District Court for the Central District of California securities fraud suit Merkamerica Inc. v. Glover, by contrast, were deemed to have satisfactorily pled their claims. In that case, investors who bought Kowala's token, kCoin — a crypto token that the defendants never actually intended on mining — based on misrepresentations made by Kowala's managers brought a securities fraud lawsuit against those managers.
The court decided in December 2019 that the plaintiffs had alleged their fraud claim with enough particularity to survive the motion to dismiss.
Going forward, a key issue in all of these fraud and Securities Act suits styled as putative class actions will be whether the courts indeed certify the cases as class actions.
So far, there's only been one class certified by a court in a cryptocurrency class action: Williams v. KuCoin. The Southern District of New York in February certified the class in that case as any buyers who purchased or sold the same token as the named plaintiff, as opposed to the customers for KuCoin's full portfolio of tokens. The court certified the class even though, with just 26 members, the size fell into a gray area for the numerosity requirement for class actions.
Central to the court's approval was that the plaintiffs would be better off proceeding as a class, rather than as individuals, given the relatively modest amount in controversy for each individual and that "the issues which are common to the class predominate over individualized ones because most all elements of plaintiffs and each proposed class member's claims present questions that are susceptible to class-wide resolution."
The plaintiffs voluntarily dismissed the case in June before the court reached any decision on the merits.
Conclusion
As we await further developments on the critical issue of class certification, there are other items that crypto companies, and the investors watching them, may want to note and assess.
To decrease the likelihood of a fraud or misrepresentation claim, crypto companies and those associated with them should be careful to be factual and not excessive in their touting of the perceived merits of a coin or platform. Further, crypto companies and investors should track recently filed lawsuits for any major updates, including the SEC lawsuits, and keep updated on any new SEC regulations.
[1] As to celebrity promoters, see, e.g., In Re: EthereumMax Investor Litigation, Docket No. 2:22-cv00163 (C.D. Cal., Jan. 7, 2022).
[2] See U.S. v. Zaslavskiy , 2018 WL 4346339 (E.D.N.Y. Sept. 11, 2018). Court decided that prosecutors could move forward with their criminal securities case against Zaslavskiy, who admitted to defrauding investors in initial coin offerings (ICOs) for two cryptocurrencies which he claimed to be backed by real estate and diamonds. The judge decided that an ICO qualified as an "investment contract" under the Howey test.
*This was republished with permission from Law360. Click here to access the publication.
