Written by Joseph N. Blinick, Alan P. Gardner and Conrad Druzeta
As mainstream interest in blockchain technology, cryptocurrencies and initial coin offerings increases, so too does the size of the market and the associated litigation risks. At its peak in early January of this year, the market capitalization of global cryptocurrencies was over US$800 billion before crashing, followed by a modest rebound settling just above of US$550 billion (…for the moment). The unprecedented volatility of cryptocurrencies amplifies a multitude of risks for investors, issuers, promoters, exchanges and all market participants alike.
Volatility of this magnitude combined with massive pools of capital in this largely unregulated, new Wild West has attracted increasing amounts of interest from the public, but also increasing amounts of scrutiny, not only from regulators, securities administrators and tax authorities worldwide, but also from civil litigants who allege they have been financially harmed in their involvement with various offerings or services in connection with cryptocurrencies. To date, cryptocurrency litigation has focused on either coin issuers or cryptocurrency exchanges as the main offenders. However, the legal landscape is rapidly evolving and we are seeing an abundance of varied litigation, including regulatory and civil actions and, particularly, class actions, in the United States. We expect to see similar activity in Canada in the year ahead.
Fertile Ground for Litigation
Valuation, liquidity and custody issues, lack of regulatory oversight, and the potential for manipulation all contribute to the inherently risky nature of this growing market. Many aspects of blockchain technology on which cryptocurrencies are based is exceedingly complex and can be fraught with clandestine exploitive opportunities for hackers, whales (the big money players), and those with nefarious intentions looking to benefit from the relative unsophistication of most investors and users. One notable example occurred in 2016 when hackers stole 3.6 million tokens of Ether (at the time valued at approximately US$50 million) by exploiting a vulnerability in the Decentralized Autonomous Organization built by Slock.it that was holding these tokens on behalf of investors. The DAO was intended to provide investors with a democratic say on how the invested funds would be applied, with greater say being given to those who contributed more value to the fund. Unfortunately, hackers exploited an error in the smart contract governing the DAO and absconded with much of the Ether it was holding. This is just one of many examples of how complex technology coupled with the anonymous nature of transactions, lack of regulatory oversight and large pools of capital can be a recipe for disaster when the risks are not properly understood and managed.
On the regulatory side, in the United States, the Securities and Exchange Commission (SEC) has been actively clamping down on fraud and other misconduct in the market. For instance, the Cyber Unit division of the SEC recently charged PlexCorps, a Montreal startup, and its founders with fraud in connection with its ICO where it promised investors 1,354% profit in less than a month. The AMF (Québec's securities regulator) also sanctioned PlexCorps and its founders, and one of those founders eventually jailed in Québec. Another noteworthy action by the SEC was its recent shutting down of the Munchee ICO based on its alleged violation of securities registration provisions, resulting in the company being forced to return the $15 million it raised in its ICO. The underlying takeaway here is that coin offerings are increasingly viewed as securities, and market participants whose conduct falls outside the regime will be subject to increasing regulatory action.
Regulatory scrutiny has not overlooked lawyers and other professionals advising and working with cryptocurrency ventures. The chairman of the SEC very recently commented that lawyers who have assisted with ICOs may be breaching their professional duties, portending that such professionals may be the target of future disciplinary actions themselves. The chairman remarked that it was “disturbing” that some lawyers were assisting promoters with what were essentially securities offerings without complying with applicable securities laws. The chairman advised that he had “instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.”
Consistent with the increased regulatory activity, market participants have also been subject to increasing exposure to civil litigation, particularly class actions. As investor protections that are present in traditional securities and financial markets are conspicuously absent in most ICOs and cryptocurrency-related services, with few barriers to entry for curious and often inexperienced investors lured by the hopes of massive gains, parties are now looking to the courts for private remedies to address alleged wrongdoing and recover lost funds. Some of the more notable cases we have seen in the United States are briefly described below.
Class Actions in the United States
BitConnect is a lending and exchange platform that offered several programs, including one where investors would purportedly receive tokens and significant returns on invested funds (to the tune of 40 percent monthly), which returns would be generated by BitConnect’s proprietary bot trading and volatility software. Earlier this month, after receiving two cease and desist letters from securities regulators in the United States, BitConnect shuttered its lending and exchange platform. No less than a week later, investors in BitConnect launched a class action. The companies behind BitConnect, as well as the founders and promoters of the platform, are all named in the action. The claim alleges that BitConnect issued tokens that were effectively unregistered securities and it operated a wide-ranging Ponzi scheme, paying out earlier investors with new investors’ funds. At its peak, BitConnect had a market cap of approximately US$2.5 billion.
Tezos is a startup developing its own digital coin, the development of which was supported by an ICO which raised over US$230 million. Shortly after the raise, infighting allegedly began amongst the founders and development of the coin slowed drastically. Eventually, the coin lost almost half of its value, much to the dismay of investors. As a result, the company as well as its founders and others involved in the ICO, including a public relations firm that allegedly promoted it, are facing numerous class action lawsuits. In the claims, plaintiffs have alleged that Tezos failed to register the coin with the SEC as required, and it made several misrepresentations to the putative class. Additionally, there has been an application for a restraining order (the U.S. equivalent to an injunction) seeking to freeze Tezos’ digital assets before they become unrecoverable.
Kraken, the largest Bitcoin exchange in euro volume and liquidity, was the target of a distributed denial of service attack that occurred simultaneously with the exchange receiving a large sell order for Ether, triggering a crash of Kraken’s website. During the attack, users could not manage their accounts. Trading was not suspended and customer accounts were liquidated. Following this event, five plaintiffs filed a class action against Payward, the company doing business as Kraken, claiming that if the exchange had functioned properly, they could have managed their accounts and avoided liquidation. The plaintiffs, alleging negligence, breach of contract and unjust enrichment, are seeking to recover over US$5 million lost due to Kraken’s conduct. The plaintiffs collectively lost 3,414.078 Ether, valued at approximately US$350,000 when it was liquidated. Today, that same volume of Ether is valued at approximately US$4 million (…for the moment).
ATB Coin, touted as a fast and inexpensive blockchain-based payment system, is facing a class action after electing not to register its ICO with the SEC. The class action alleges that the coin, ATBCoin, should be considered a security and failure to register it as such violated securities laws. The suit, filed in New York, names not only ATBCoin LLC but also its CEO and its co-founder as defendants.
In similar fashion to Tezos and ATB Coin, the cryptocurrency startup, Centra, has been accused of violating securities laws and is now facing a class action. It is alleged that between July and October 2017, Centra raised over US$30 million by offering and selling unregistered securities. Centra’s novel value proposition was that it would use the capital to develop a debit card that would integrate numerous cryptocurrencies and offer faster transactions in addition to the ability to withdraw fiat currency. Centra used certain celebrity endorsements to increase the notoriety of the ICO, though Floyd “Money” Mayweather, one of the endorsers, has not been named in the suit.
Potential Action Against Other Exchanges
There has also recently been considerable discussion in online forums and other mediums about further potential legal action against widely used exchanges for deposit and withdrawal issues, downtime and delays in the execution of trades, price manipulation, insider trading and other related issues.
Legal Bases for Liability
While the class actions in the United States have largely been framed around alleged breaches of securities laws, as noted, we are also seeing claims being advanced under other well-developed theories of liability and well-established causes of action such as civil fraud, breach of contract, unjust enrichment and misrepresentation. Claims are also being advanced under existing consumer protection legislation.
Class Actions in Canada
Though we have yet to see the same level of litigation activity in Canada, we expect it is only a matter of time before plaintiffs take up the fight here, particularly given the relatively low bar for certification of class actions in Canada and the tendency of Canadian plaintiff’s counsel to launch copycat suits. The U.S. class actions discussed above not only highlight what is inevitably to come, but they also help underscore the need for all market participants to appropriately structure their affairs, implement adequate security protocols and take active and diligent steps to mitigate risk, particularly in the face of rapid market growth and increasing scrutiny from regulators and investors.
We are seeing some phenomenal technological changes propelled by innovative companies and individuals developing new products, services and entire business models based on blockchain technology. These parties are moving away from traditional financing toward ICOs, air-dropping and other more novel forms of funding for their businesses. However, with that, and with the anonymous and international nature of transactions, the multitude of parties involved (issuers, advisors, promoters, investors, banks, exchanges, hackers, etc.), the inability of regulatory oversight to keep pace, and the great disparity in the sophistication of market participants, among other factors, a perfect storm is brewing, and growing.
As we have seen in the United States, the cryptocurrency space is providing fertile ground for civil litigation, particularly class actions. We expect this trend to surge as more mainstream acceptance of blockchain technology, cryptocurrencies and ICOs happens. It is not all FUD though. As the risk of facing a Canadian class action expands, there are existing and emerging tools creative defence counsel can use to blunt even the most aggressive plaintiffs’ counsel tactics. Bennett Jones LLP is ready to assist its clients in navigating the challenges that inevitably lie ahead in this exciting and dynamic space. If you are interested in discussing this further, please contact the Bennett Jones Blockchain & Fintech or Class Actions groups.
*This article assumes a certain baseline knowledge of cryptocurrencies, ICOs and blockchain technology. If there are any terms used in this article with which you are unfamiliar, or any subject matter about which you have questions, please let us know (or do some googling as this is an interesting and exciting new frontier).
Special thanks to articling student David St. Bernard for his assistance with preparing this article.