Cryptocurrency

Cryptocurrency Litigation On The Rise – Fin Tech

The third quarter of 2022 has seen a dramatic uptick in
incidences of federal cryptocurrency litigation. The common
questions that are being asked of the courts are whether certain
cryptocurrency assets are to be treated as a commodity and/or a
security? Investment groups, the Commodity Futures Trading
Commission (CFTC), and the Securities Exchange Commission (SEC)
have begun filing a host of lawsuits across the federal district
courts, five major lawsuits alone in the months of September 2022
and October 2022. Perhaps, this is indicative of an uptick in cases
being filed across other jurisdictions.

What are Securities?

Before diving further, we should look to the Securities Exchange
Act’s definition of what a “security” is, and it is
defined broadly to include, among other things, stocks, bonds,
debentures, investment contracts, a variety of other instruments,
or, “in general, any instrument commonly known as a
‘security.'” 15 U.S.C. § 78c(a)(10). Yet, the
definition of security expressly excludes “currency or any
note, draft, bill of exchange, or banker’s acceptance which has
a maturity at the time of issuance of not exceeding nine months,
exclusive of days of grace, or any renewal thereof the maturity of
which is likewise limited.” 15 U.S.C. § 78c(a)(10).

In general, all securities offered in the United States must be
registered with the SEC or must qualify for an exemption from the
registration requirements. Securities which are generally exempt
include government bonds, agencies, municipal bonds, commercial
paper, and private placements. If a broker or dealer is going to be
effecting transactions in securities for an account or others, or
for their own accounts, they are generally required to register
with the SEC and join a “self-regulatory organization.”
15 U.S.C. § 78o. Like with registering securities, the law
does have exemptions for brokers and dealers who do not have to
register.

This appears to be where selling and marketing cryptocurrency
assets skates a very skewed line and raises questions for both
investors and regulators as to whether cryptocurrency assets should
in fact be considered a security and be registered with the
SEC.

The SEC Laws at issue

In general, issues have arisen with cryptocurrency assets in the
context of whether investment contracts exist. The United States
Supreme Court in the Howey decision, and its subsequent
case law, found that investment contracts exist when there is the
investment of money in a common enterprise with a reasonable
expectation of profits to be derived from the efforts of others.
SEC v. W.J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90
L.Ed. 1244 (1946). The Howey analysis applies to any
contract, scheme, or transaction, regardless of whether it has any
of the characteristics of typical securities.
https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_ednref6
.
Depending on the facts or circumstances surrounding an individual
case, it is possible for a cryptocurrency asset to be considered a
security by virtue of it being an investment contract.

If a cryptocurrency asset is deemed to be a security, a broker
or dealers trading of an unregistered asset could lend itself to
potential liability. Section 10(b) of the Securities Exchange Act
of 1934 makes it unlawful to “use or employ, in connection
with the purchase or sale of any security” a
“manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the [SEC] may
prescribe.” 15 U.S.C. § 78j(b). Further, SEC Rule 10-b5,
makes it unlawful for any person to defraud or deceive someone,
including through the misrepresentation of material information,
with respect to the sale or purchase of a security.

Taking the fraud liability further, the offer and sale of
securities, by the use of the means and instrumentalities of
interstate commerce, directly or indirectly have: (a) employed
devices, schemes and artifices to defraud; (b) obtained money or
property by means of untrue statements of material fact or by
omitting to state material facts necessary in order to make the
statements made, in light of the circumstances under which they
were made, not misleading; and (c) engaged in transactions,
practices, or courses of business that operated or would operate as
a fraud or deceit upon the purchasers of such securities under
Section 17(a) of the Securities Exchange Act. 15 U.S.C. §
77q.

Section 5(b) of the Securities Exchange Act makes it unlawful
for any person to directly or indirectly: (a) make use of means or
instrumentalities of transportation or communication in interstate
commerce or of the mails to sell, through the use or medium of a
prospectus or otherwise, securities as to which no registration
statement was in effect; (b) for the purpose of sale or delivery
after sale, carry or cause to be carried through the mails or in
interstate commerce, by means or instrumentalities of
transportation, securities as to which no registration statement
was in effect; and (c) make use of means or instrumentalities of
transportation or communication in interstate commerce or of the
mails to offer to sell or offer to buy, through the use or medium
of a prospectus or otherwise, securities as to which no
registration statement had been filed. 15 U.S.C. § 77e(a) and
(c).

Recent SEC Cases

Securities and Exchange Commission v. Chicago Crypto Capital
LLC et al

In the Northern District of Illinois, the SEC has brought a
civil action against Chicago Crypto Capital LLC (“Chicago
Crypto”), its president and sole owner Brian B. Amoah, and two
of its salesman, Darcas Oliver Young and Elbert G. Elliott. The
allegations were that Crypto Capital, it’s owner, and
salespeople conducted an unregistered offering of cryptocurrency
assets called BXY, which the SEC contends was a security, illegally
raising $1.5M in proceeds through unregistered offers and sales of
the securities to about 100 individuals, many of whom were
cryptocurrency novices. The allegations are that the BXY offering
was not registered with the SEC and did not meet any exemption from
registration.

Adding to the issues, none of the defendants were registered
with the SEC as brokers, and the allegations are that the
defendants effected transactions in BXY for Chicago Crypto
customers’ accounts, advised prospective investors about the
merits of investing in BXY, and received transaction-based
compensation. There were also allegations of fraud in that the
defendants misled investors about the custody and delivery of BXY,
and made false and misleading statements about the markup charged
by Chicago Crypto, the delivery of account statements, Chicago
Crypto’s liquidation of an investor’s BXY, their personal
investments in BXY, and the financial and management problems
occurring at BXY’s issuer, Beaxy Digital Ltd., in late 2019.
This resulted in the SEC seeking relief under 5 counts in their
complaint for violations of Sections 5(a), 5(c), 10(b), 15(a), and
17(a) of the Securities Exchange Act.

U.S. Securities and Exchange Commission v. The Hydrogen
Technology Corporation et al

In the Southern District of New York, the SEC brought another
civil action. This time it was against The Hydrogen Technology
Corporation (“Hydrogen Tech”), its President and CEO
Michael Ross Kane, and Tyler Oster, President and CEO of
Moonwalkers Trading Limited (“Moonwalkers”). The
allegations are that during January 2018 and April 2019, Hydrogen
Tech and Kane offered and sold cryptocurrency asset securities
called Hydro tokens, and hired Ostern and Moonwalkers to
fraudulently manipulate the price and volume of Hydro tokens traded
on cryptocurrency asset trading platforms so that Hydrogen Tech
could sell its own Hydro tokens at a greater profit.

The allegations state that Ostern and Moonwalkers used a
customized trading bot through Kane’s and Hydrogen Tech’s
trading accounts to sell Hydro tokens. It resulted in $2.2M in
profits for Hydrogen Tech. Among other manipulation tactics, Ostern
allegedly placed and canceled both buy and sell orders at random
increments to artificially inflate the Hydro token’s trade
volume and price, thereby enabling sales of the company’s Hydro
to be more profitable.

The SEC contends that Hydro tokens distributed by Hydrogen Tech
and Kane through the bounty programs, employee compensation, and
sales in the crypto asset trading market, including through Ostern,
were offered and sold as investment contracts, and therefore were
securities whose offer or sale required registration with the SEC
unless an exemption from registration was available. Ultimately the
SEC brought this suit seeking relief under 6 counts in their
complaint for violations of Sections 5(a), 5(c), 9(a), 10(b),
15(a), 17(a) and 20(b) of the Securities Exchange Act.

What are Commodities and What are the Laws at
Issue?

The CFTC defines a commodity as (1) those articles including
agricultural commodities enumerated in Section 1a(4) of the
Commodity Exchange Act, 7 USC 1a(4), and all other goods and
articles, except onions as provided in Public Law 85-839 (7 USC
13-1), a 1958 law that banned futures trading in onions, and all
services, rights, and interests in which contracts for future
delivery are presently or in the future dealt in; and (2) physical
commodities such as an agricultural product or a natural resource
as opposed to a financial instrument such as a currency or interest
rate.

The CFTC has posted on its website that virtual currencies, such
as Bitcoin and other cryptocurrencies have been determined to be
commodities under the Commodity Exchange Act. Further, per the
CFTC, the CFTC’s jurisdiction in cryptocurrency assets is
implicated when a virtual currency is used in a derivatives
contract, or if there is fraud or manipulation involving a virtual
currency traded in interstate commerce.

The Commodity Exchange Act generally requires intermediaries in
the derivatives industry to register with the CFTC. An
“intermediary” is a person or firm who acts on behalf of
another person in connection with trading futures, swaps, or
options. Depending on the nature of their activities, they may also
be subject to various financial, disclosure, reporting, and
recordkeeping requirements. Intermediaries include: Associated
Persons (AP), Commodity Pool Operators (CPO), Commodity Trading
Advisors (CTA), Floor Brokers (FB), Floor Traders (FT), Futures
Commission Merchants (FCM), Introducing Brokers (IB), Principals
Retail Foreign Exchange Dealers (RFED), and Swap Dealers (SD).

Recent CFTC Cases

Commodity Futures Trading Commission v. Todd et al

In the Southern District of Florida, the CFTC brought an action
against Adam Todd, Digitex LLC, Digitex Limited, Digitex Software
Limited, and Blockster Holdings Limited Corporation (d/b/a Digitex
Futures). The allegations are such that Adam Todd purportedly
owned, built, and operated an asset derivatives trading platform
through a common enterprise of corporate entities, including
Digitex LLC, Digitex Limited, Digitex Software Limited, and
Blockster Holdings Limited Corporation (all referred to in the
complaint as “Digitex Futures” collectively). The
pleadings argued that Digitex Futures accepted customer funds as
margin collateral and matched customer orders for digital asset
derivatives, such as bitcoin futures contracts and ether futures
contracts. In connection with its offering of digital asset futures
contracts, Digitex Futures allowed users to trade with leverage of
up to 100 to 1. The CFTC is arguing that through the operation of
their exchange platform, Digitex Futures became subject to the
requirements under Section 4 of the Act, 7 U.S.C. § 6, to
register with the Commission as a designated contract market
(“DCM”) or foreign board of trade (“FBOT”), as
well as the requirement under Section 4d of the Act, 7 U.S.C.
§ 6d, to register as a futures commission merchant
(“FCM”). The CFTC contended that neither Digitex Futures
nor Todd had ever been registered with the Commission in any
capacity and therefore violated 7 U.S.C. §§ 6 and 6d.

Because of the CFTC’s argument that Digitex Futures also met
the statutory definition of an FCM, Regulation 42.2, 17 C.F.R.
§ 42.2 (2021), it required Digitex Futures to comply with the
applicable provisions of the Bank Secrecy Act (“BSA”),
including requirements to implement effective know-your-customer
(“KYC”) procedures and a customer information program
(“CIP”). However, the CFTC believes that Digitex Futures
did not have effective KYC procedures at any time and it believes
that Digitex Futures did not implement an effective CIP, thus
violating 17 C.F.R. § 42.2. Lasty, the CFTC sought relief for
a purported attempt by Todd to manipulate the price of the Digitex
Futures native currency, DGTX, by engaging in non-economic trading
activity on third-party digital asset trading platforms with the
intent to artificially inflate the price of DGTX and increase the
value of the DGTX tokens held by Todd and Digitex Futures for their
benefit. This resulted in the pleading having counts for violations
of Section 6(c)(1), 6(c)(3), and 9(a)(2) of the Act, 7 U.S.C.
§§ 9(1), 9(3), and 13(a)(2), and Regulations 180.1(a)(1)
and 180.2, 17 C.F.R. §§ 180.1(a)(1), 180.2 (2021).

Commodity Futures Trading Commission v. Ooki DAO

In the Northern District of California, the CFTC brought an
action against Ooki DAO. The company bZeroX, LLC
(“bZeroX”) designed, deployed, marketed, and made
solicitations concerning a blockchain-based software protocol (the
“bZx Protocol”) that accepted orders for and facilitated
margined and leveraged retail commodity transactions. The
allegations are that the bZx Protocol permitted users to contribute
margin to open leveraged positions whose ultimate value was
determined by the price difference between two virtual currencies
from the time the position was established to the time it was
closed. Additionally, the CFTC alleged the bZx Protocol purportedly
offered users the ability to engage in the transactions in a
decentralized environment. Further, bZeroX, having never registered
with the Commission, purportedly engaged in unlawful activities
that could only lawfully be performed by a registered designated
contract market (“DCM”) and other activities that could
only lawfully be performed by a registered futures commission
merchant (“FCM”) under the Commodity Exchange Act, 7
U.S.C. §§ 1-26, and Commission Regulations, 17 C.F.R.
pts. 1-190 (2021).

In addition, the CFTC alleged that bZeroX failed to conduct KYC
diligence on its customers as part of a CIP as required of FCMs by
the Regulations. In August 2021, bZeroX transferred control of the
bZx Protocol to the bZx DAO, which was later renamed and currently
doing business as Ooki DAO. Ooki DAO is an unincorporated
association comprised of holders of Ooki DAO Tokens who vote those
tokens to govern the bZx Protocol (renamed the “Ooki
Protocol”). The CFTC alleged that bZeroX transferred the bZx
Protocol to bZx DAO, in an effort to circumvent the Commodities
Exchange Act and other Regulations. The CFTC brought the action
violation of Sections 4(a) and 4d(a)(1) of the Act, 7 U.S.C.
§§ 6(a), 6d(a)(1), and Regulation 42.2, 17 C.F.R. §
42.2 (2021), and is seeking relief.

Specifically, the pleading states that Ooki DAO operated,
marketed, and made solicitations concerning the Ooki Protocol,
accepting orders for and facilitating margined and leveraged retail
commodity transactions. Further allegations purported that Ooki DAO
existed for the exact same purpose as bZeroX in running a business,
and specifically, operating and monetizing the Ooki Protocol. The
Ooki DAO allegedly did so via the votes of Ooki Token holders who,
through their votes, chose to participate in running the business.
Just like the bZx Protocol, the Ooki Protocol allegedly permitted,
and continued to permit, users to contribute margin collateral to
open leveraged positions whose value was determined by the price
difference between two virtual currencies from the time the
position was established to the time it was closed. The Ooki
Protocol purportedly offered users the ability to engage in the
transactions in a decentralized environment. In so doing, the
unregistered Ooki DAO was purportedly engaging in unlawful
activities that can only lawfully be performed by registered DCMs
and other activities that can only lawfully be performed by
registered FCMs under the Commodities Regulations. In addition, the
CFTC argued that Ooki DAO does not conduct KYC diligence on its as
part of a CIP, as required of FCMs by the Commodities
Regulations.

Investment Group Class Action

Laffoon v. Coinbase Global, Inc. et al

In District Court of New Jersey, a group of disgruntled
investors brought a class action lawsuit against Coinbase Global
(“Coinbase” or the “Company”), Brian Armstrong,
Alesia J. Haas, and Emilie Choi for securities violations. The
allegations are that Coinbase misrepresented and/or failed to
disclose (1) crypto assets Coinbase held as a custodian on behalf
of its customers could qualify as property of a bankruptcy
estate—and not the Company’s customers—in the event
Coinbase filed for bankruptcy; (2) Coinbase allowed Americans to
trade crypto assets that the Company knew or recklessly disregarded
should have been registered as securities with the SEC; (3)
Coinbase had plans to, and did in fact, engage in proprietary
trading of crypto assets; and (4) as a result, Defendants’ made
statements about the Company’s business, operations, and
prospects lacking a reasonable basis and misled investors regarding
material risks attendant to Coinbase’s operations. The main
issue setting up this cause of action was the untimely disclosure
that “because custodially held crypto assets may be considered
to be the property of a bankruptcy estate, in the event of a
bankruptcy, the crypto assets [the Company] hold[s] in custody on
behalf of our customers could be subject to bankruptcy proceedings
and such customers could be treated as our general unsecured
creditors.” Later, Defendant Brian Armstrong, who was the CEO
and co-founder of Coinbase, told investors on Twitter that Coinbase
“should have updated [its] retail terms sooner” and
acknowledging that the Company “didn’t communicate
proactively.” News of this broke and purportedly caused media
attention and diminution of Coinbase’s common stock, causing
investors to take action for damages. The complaint pled two counts
for violations of Sections 10(b) and 20(a) of the Securities
Exchange Act.

Conclusion

As the new year approaches, we anticipate that these filings
will continue to become more and more prevalent. Investors and the
Federal Commissions themselves are becoming wiser regarding the
exact nature of crypto assets and crypto asset schemes. The firm
has begun to see issues here in the State of Florida where brokers
and dealers are failing to register with the SEC and/or the CFTC in
trading of articles that under the statutory definitions are
securities and/or commodities that should also be subject to
registration. The firm is monitoring these dockets closely as the
cases continue to progress. If you or any person you know has
suffered damage in trading or purchasing unregistered securities or
commodities without proper disclosures, please do not hesitate to
contact us to discuss your options.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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