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The Face of Blockchain Litigation

Fariha J. Momin

The Face of Blockchain Litigation

A blockchain is an electronic ledger that records transactions in real-time and is continuously updated upon transaction confirmation by multiple nodes on the network. The ledger is distributed on a network of different servers, or "nodes," so it does not rely on a single intermediary. Each node retains a separate live-copy of the ledger, making it difficult to manipulate. The technology can be fully decentralized or partially decentralized, depending on the needs of the users. Fully decentralized means that the ledger is open to anyone, while partially decentralized means that only certain approved nodes or users can make changes. Private ledgers are fully controlled by a single entity. The technology is highly secure and adaptable to different groups of transactions and users. Think of it as a widely or narrowly shared, cryptographically secure database that is continuously and quickly updated via the consensus of nodes.

Lessons from Litigations

The Department of Justice (DOJ) has used traditional criminal laws, such as money laundering and wire fraud, to prosecute cryptocurrency-related offenses. The DOJ has successfully prosecuted several cases, including illegal bitcoin transactions, fraudulent coin offerings, money laundering, and operation of unlicensed bitcoin-for-cash exchange businesses. The DOJ has also indicted individuals involved in the Bitmex exchange for violations of the Bank Secrecy Act and conspiracy. Courts consistently hold that labeling an investment opportunity as virtual currency or cryptocurrency does not transform an investment contract into a currency.

The Securities and Exchange Commission (SEC) is a leading source of litigation, looking more at regulatory activity as opposed to criminal and fraudulent actions. (1) Courts have easily issued restraining orders or injunctions against alleged offenders. (2) Entities regularly fail to convince courts that their cryptocurrency is not a security. (3) The SEC is expanding its crackdown beyond initial coin offerings (ICOs) to include unregistered exchanges and broker-dealers, pushing into decentralized finance. (4) SEC efforts provide companies with compliance mechanisms, but entities are resistant. (5) Telegram and Kik litigation hint SAFT and related models may face significant hurdles in SEC lawsuits.

The Commodity Futures Trading Commission (CFTC) has increased its prosecutorial activity with respect to cryptocurrency derivatives and has initiated federal litigations and administrative proceedings against market participants. Cryptocurrency derivatives such as options, futures, and swaps for which a unit of virtual currency is the underlying interest, are treated as commodity interests under the Commodity Exchange Act (CEA) and CFTC rules. Judge Weinstein held that the CFTC had standing to sue defendants for violations of the CEA through trading and purchasing of cryptocurrencies in CFTC v. McDonnell and CabbageTech, and this view was supported by the court's findings of fact, conclusions of law, and directions for final judgment and injunction. The CFTC also asserted jurisdiction and obtained a default judgment order in CFTC v. Dean and The Entrepreneurs Limited against individuals and a corporate defendant who operated a Bitcoin-funded commodity pool. However, CFTC jurisdiction over cryptocurrencies as "commodities" under the CEA is not a foregone conclusion. Some defendants have contested the classification of cryptocurrencies as commodities, arguing that the plain language of the CEA does not include intangible "services, rights and interests" unless futures contracts are traded on them.

The US government has been active in regulatory enforcement of cryptocurrencies. The Financial Crimes Enforcement Network (FinCEN) has assessed civil penalties in cases involving money laundering and Bank Secrecy Act violations. The Federal Trade Commission (FTC) has brought unfair competition cases resulting in permanent injunctions and monetary judgments. The Internal Revenue Service (IRS) has been monitoring cryptocurrency markets and has filed petitions to enforce summons for information on cryptocurrency exchange users. State securities administrators have also been active in regulatory enforcement, with the North American Securities Administrators Association announcing Operation Cryptosweep resulting in nearly 70 inquiries and investigations and 35 pending or completed enforcement actions. Notably, the Attorney General of New York has filed several challenges for alleged violations of N.Y. General Business Law Article 23-A, and continues to be a frontline litigator in many disputes.

Private litigation has been triggered by cryptocurrency issues, leading to traditional securities or corporate litigation in the crypto setting. Cases have been filed against prominent ICO issuers and exchanges alleging misrepresentations or omissions in the sale of cryptocurrency. Intellectual property rights and contracting rights relating to ownership are picking up attention with more traditionally-structured companies exploring blockchain. Some of these cases have been dismissed due to legal defenses like extraterritoriality, service of process issues, and statutes of limitations. Assuming plaintiffs can prove that the cryptocurrency is a security, these cases will likely play out similarly to traditional securities class action cases.

Litigation Looking Ahead

The cryptocurrency market is facing increased regulatory scrutiny and legal risks from several angles. Exchanges are particularly vulnerable to private lawsuits since no cryptocurrency exchange has been approved by the SEC yet, and have operated as regulated money services businesses (MSBs). While there is a possibility that a comprehensive set of rules for cryptocurrency exchanges that provides immunities similar to traditional exchanges and alternative trading systems may be created in the future, cryptocurrency exchanges currently bear extra litigation risk. The SEC and CFTC are still grappling with whether to allow cryptocurrency futures and derivatives to trade. Cryptocurrency futures and derivatives have been gaining popularity, but the CFTC has not taken any enforcement action simply for trading or allowing the trade of cryptocurrency futures or derivatives. Decentralized autonomous organizations for financial business, collectively known as DeFi, have gained tremendous popularity, presenting a new opportunity for decentralized networks to bring new services and products to new markets, but also represent a regulatory challenge. The SEC is studying DeFi closely and is asking whether such organizations are truly decentralized, or whether the purported decentralization is a sham to evade federal securities laws. Regulatory attention will likely also spark regulators to eye cryptocurrency and cryptocurrency derivative products for insider trading abuses, reflecting some rug pulls in the arena. Finally, pump-and-dump schemes will continue challenging the cryptocurrency realm.

Despite the regulatory scrutiny and legal risks faced by the cryptocurrency market, it continues to evolve and innovate. Cryptocurrency exchanges and DeFi are expanding the reach and accessibility of financial services, and blockchain technology has the potential to revolutionize industries beyond finance. As litigators and lawyers, it is important to stay informed and adapt to the changing legal landscape of the cryptocurrency market. By doing so, we can help shape the legal framework that will guide the development of this exciting and dynamic technology, ensuring that it is both secure and accessible to all. Embracing the challenges and opportunities presented by blockchain litigation, litigators continue to work towards a future where blockchain technology can be utilized to its full potential in safe and secure ways.

This article was prepared by the Business Law Section's Business and Corporate Litigation Committee.