With increased regulatory oversight of and recent turmoil in digital asset markets, the frequency of securities litigations concerning cryptocurrencies has also risen. As with any evolving industry, litigators are constantly faced with unpredictable outcomes and complex issues. Two issues at the forefront of recent cryptocurrency litigations are these:
This article provides an overview of cryptocurrencies, reviews recent regulatory developments of the cryptocurrency industry, analyzes the recent rise in securities litigations concerning cryptocurrencies, and evaluates how courts have dealt with these issues thus far. Throughout the article, you will find practical tips for litigators on both sides of the case to consider.
Cryptocurrency, or crypto, is a digital payment system that, at its core, is decentralized. Rather than relying on traditional banks, or a central, authoritative system of control, cryptocurrency exists based on a peer-to-peer system in which transactions are verified by other users and input into a ledger.
A cryptocurrency exchange is the platform that allows customers to trade cryptocurrencies for other assets, such as conventional money (fiat currency) or other digital currency. Exchanges can act as brokers, taking bid-ask spreads as a transaction commission, or exchanges can act as direct trading platforms and charge transaction fees to users of the service. Often cryptocurrency exchanges operate outside the U.S. to avoid regulation and prosecution (adding to the second common problem, extraterritoriality, in cryptocurrency-related cases).
Finally, a cryptocurrency wallet (1) stores digital currency account information in an encrypted format, (2) interacts with one or more blockchains (a digital public ledger), and (3) enables users to send and receive digital currency and monitor their balance. A cryptocurrency wallet does not actually store digital currency. Rather, the wallet stores a user’s public and private keys, which in turn allows the user to transact with other users. Thus, if users lose their keys, they’ll inevitably lose their cryptocurrency.
Due to the decentralized nature of cryptocurrency and the ability for individuals to transact anonymously and across borders with ease, regulation of cryptocurrency and cryptocurrency exchanges has been an evolving space. Because a matter involving cryptocurrency could implicate contract law, tort law, partnership law, property law, business competition law, securities law, and a host of other practice areas, this article does not attempt to cover every angle. But a few regulatory areas to remain aware of are highlighted below.
First, securities regulation is the main oversight mechanism of cryptocurrency. The U.S. Securities and Exchange Commission (SEC) continues to be the main regulator when it comes to cryptocurrency exchanges. Cryptocurrencies are subjected to federal securities laws, including the Securities Act, Exchange Act, Advisers Act, and Investment Company Act. Moreover, cryptocurrencies are subject to state blue sky laws, and many states have added even further regulatory checkpoints dealing with cryptocurrency. For example, in New York State, cryptocurrency exchanges are subject to a licensing system in which nearly any commercial transfer, sale, purchase, or issuance of virtual currency requires a license. N.Y. Codes R. & Regs. tit. 23, §§ 200.1–200.22. However, for these laws and regulations to be enforceable, the cryptocurrency must fall within the scope of the definition of a security. Also, the exchange at issue must be within the purview of U.S. courts.
Second, because cryptocurrency presents an investment opportunity, investors often face taxation. The Internal Revenue Service treats cryptocurrency as an asset, requiring users to pay taxes on cryptocurrency if they sell or use cryptocurrency in a transaction. Moreover, under the Infrastructure and Investment Jobs Act, enacted in November 2021, cryptocurrency exchanges are now mandated to send Form 1099-B (the traditional brokerages form) to all users to report yearly profits and losses of cryptocurrency assets. Infrastructure and Investment Jobs Act, H.R. 3684, 117th Cong., 1st Sess. (2021).
In 2022, as cryptocurrencies plummeted in value, related lawsuits ensued. Experts in the industry have dubbed the meltdown a “crypto winter.” Farshad Ghodoosi, “Crypto Litigation: An Empirical View,” 40 Yale J. Reg. 87 (2022).
The uptick in litigations concerning cryptocurrency in 2022 should not have come as a surprise. Over the past few years, the SEC has continued to echo its call on Congress to give the agency more authority to regulate the cryptocurrency space. The call was answered in May 2022 when the SEC nearly doubled the size of the Crypto Assets and Cyber Unit, which enhanced the unit’s ability to focus on investigating securities law violations related to crypto asset offerings, exchanges, lending and staking products, decentralized finance platforms, non-fungible tokens, and stablecoins. Press Release, SEC, SEC Nearly Doubles Size of Enforcement’s Crypto Assets and Cyber Unit (May 3, 2022).
This increase in enforcement of securities laws by the SEC not surprisingly increased litigations concerning cryptocurrency in comparison with previous years.
Jurisdictionally speaking, New York and California have been the go-to jurisdictions for cryptocurrency litigation. In 2022, roughly 70 percent of all cases were filed in New York or California. Ghodoosi, supra, at 94. About 44 percent of all cryptocurrency cases were brought as class actions on behalf of individual investors. Id. at 95. Further, a review of the specific causes of actions asserted reveals that securities allegations and tort claims accounted for more than half of the causes of action in cryptocurrency suits. These allegations most often arise with claims asserting securities law violations for unregistered securities, combined with negligent misrepresentation and fraud. Id. at 96.
The SEC continues to be the main regulator in the cryptocurrency space. Its actions have focused on two allegations: (1) unregistered securities offerings and (2) fraudulent securities offerings or sales. While pursuing these allegations, two key issues have come to the forefront of most of these cases: (1) whether the cryptocurrency in question is a security and (2) extraterritoriality—whether the transactions are domestic and therefore within the purview of U.S. courts.
Often the threshold issue in these cases is whether the asset at issue is a security at all and therefore subject to regulation by the SEC. The SEC has increasingly taken the stance that cryptocurrencies are a form of investment contracts and, therefore, are securities. To make this determination, courts employ the Howey test, referring to SEC v. W.J. Howey Co., a Supreme Court case in 1946 that dealt with a company’s sale and leasing of citrus groves. SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Factually, the case could not be more inapposite to the rise of the twenty-first-century developments in cryptocurrency. Yet, the test that emerged from the case remains the go-to way of determining what qualifies as a security.
The Howey test sets out factors to determine what qualifies as an investment contract and is thus a security needing to comply with the registration requirements of the SEC. These factors include the following:
In applying the Howey test, the case of Audet v. Fraser considered for the first time via jury whether certain digital assets called “Hashlets” were a security. No. 3:16-CV-940 (MPS), 2022 WL 1912866 (D. Conn. June 3, 2022). In upholding the jury’s determination that the Hashlets were not a security, the court focused on the second and third prongs of the Howey test not being met. First, the court determined there was no “common enterprise” based on an analysis that focused on consumer expectations (how the Hashlet was supposed to work as advertised, as opposed to how it worked in reality). Because investors could make individual choices with their Hashlets and paid a flat fee to a mining company no matter how much an investor made off the Hashlet, the court found that there was no overlap in success between individual investors’ returns or between the investors’ returns and promoters’ returns. Second, the court determined that because of the significant individual control that each investor had over the success of his or her particular Hashlet, there was no expectation that a profit could be realized based on efforts of others. Rather, each investor’s success was almost solely dependent on the investor’s own efforts.
The case of SEC v. LBRY, Inc., reached the opposite conclusion by holding that a certain blockchain token called “LBC” was a security and, therefore, required registration with the SEC. No. 21-CV-260-PB, 2022 WL 16744741 (D.N.H. Nov. 7, 2022). Here too, the court focused on the consumer’s expectations when choosing to invest in the cryptocurrency and how the product was advertised. Here, the court ruled that on top of the first two prongs of the Howey test being satisfied, “LBRY’s overall messaging . . . was pitching a speculative value proposition for its digital token.” Id. at *5. Thus, the “expectation of profits” prong was met based on how the product was advertised and on consumers’ expectations, rather than on how the product worked. Id.
These two cases demonstrate that there is not a concrete answer on whether a cryptocurrency is a security, and courts will continue to grapple with this issue each time a cryptocurrency is part of a securities litigation. The mere fact that a product is offered as a cryptocurrency does not mean it will automatically need to be registered with the SEC. Rather, the fluidity of the product allows a cryptocurrency that may have originally been offered as a security to morph into a non-security depending on how it is advertised or used.
Another common threshold issue in cases about cryptocurrency is extraterritoriality. As outlined above, the decentralized nature of cryptocurrency allows investors to transact anonymously and across borders with relative ease. Yet, federal securities law applies only to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247, 267 (2010). An exchange is considered “domestic” if it registers as a “national securities exchange.” Id. Further, an exchange need only register if a facility of the exchange is “within or subject to the jurisdiction of the United States.” Id.
This is precisely one of the issues the court grappled with in Anderson v. Binance, No. 1:20-CV-2803 (ALC), 2022 WL 976824 (S.D.N.Y. Mar. 31, 2022). In Anderson, a class of investors brought suit against Binance, a cryptocurrency exchange. The court ruled that neither federal securities law nor state blue sky laws applied to Binance because of the extraterritoriality issue. The transactions were not domestic enough, even though (1) the investors were in the U.S., (2) Binance used computer servers in the U.S., and (3) Binance had employees located in California. As the court reasoned, these alleged contacts were insufficient to establish the necessary nexus to the U.S. to overcome extraterritoriality. Williams v. Block.one arrived at the same conclusion in deciding that a purchaser’s location is not determinative when dealing with the extraterritoriality issue. No. 20-CV-2809 (LAK), 2022 WL 5294189 (S.D.N.Y. Aug. 15, 2022).
While cryptocurrency faced a turbulent year in 2022, two things seem certain. First, the SEC will continue to crack down on the evolving industry, creating more case law on the topic that could establish more clarity as to when a product must be registered. Second, cryptocurrency investors, exchanges, and brokers must follow the ever-changing regulatory mechanisms that may affect their investment strategies or business models.
