Civil Litigation Risks for Offerors of Digital Tokens and Cryptocurrencies

On the heels of Bitcoin’s rapid rise in value, 2017 introduced financial markets to the initial coin offering (ICO), a novel method of raising capital modeled loosely on the traditional initial public offering and facilitated by the emergence and proliferation of distributed ledger technology, known commonly as the “blockchain.” In an ICO, the offeror typically accepts an established cryptocurrency, such as Bitcoin or Ether, in exchange for digital assets in the form of tokens or new cryptocurrencies to be exchanged via the offeror’s new blockchain. Since 2016, more than 300 entities have raised an estimated $4 billion to $6 billion in capital through digital token sales and ICOs—figures that, according to some sources, surpass amounts raised through traditional early-stage venture capital financing during the same time period.

Government authorities, including the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission, and the Department of Justice, have significantly ramped up enforcement measures to rein in perceived abuses and reduce market risk. SEC leadership, in particular, has spoken publicly about wanting to root out alleged fraud and unregistered offerings of securities as a means of protecting retail investors in this space. With the tech and legal communities focused so heavily on regulatory compliance and enforcement, offerors in this space risk overlooking civil litigation as a primary and, in many respects, equally serious, source of liability and reputational harm. In many cases, particularly close cases that are unlikely to draw the attention of government enforcement bodies, private civil actions are bound to be the primary, if not exclusive, legal touchpoint for many issuers and owners of digital assets. Recent class actions and other private litigation activity reflects that investors and customers are not waiting for the government to take action against digital asset sellers and developers who fail to meet their expectations.  

Against this backdrop, both new and established offerors should understand that compliance with securities, commodities and other federal laws are the beginning, not the end, of legal compliance. While the technology and offerings may be novel, the legal claims at issue are largely familiar terrain in civil class actions, including common law fraud, concealment and breach of contract. Two recent digital asset-sale litigations—one involving Tezos and the other involving BitConnect—showcase the great breadth of legal and practical concerns facing token issuers irrespective of their status with the federal and state authorities. Together, these proceedings provide a roadmap for offerors to plan for, and deal with, civil litigation in the aftermath of digital asset-based fund raising and sales.

BitConnect – Between January and February 2018, three separate putative classes of purchasers and investors filed suits against BitConnect, a U.K. company, and its affiliates and representatives in federal courts in Florida and Kentucky. These suits variously assert civil claims ranging from the unregistered sale of securities under federal and state law to breach of contract, fraudulent concealment, conversion, conspiracy and violations of state consumer protection statutes. BitConnect’s business model allowed users to exchange established cryptocurrencies like Bitcoin for BitConnect’s own coin, “BCC,” which users then “lent” to the platform and received interest-like payouts based on the size of the loan. The class action claims arose primarily from marketing representations made by BitConnect about specific returns that investors could expect. Notably, at least one of the suits (Paige v. BitConnect et al, No. 18-cv-58 (W.D. Ky.)) also targets an unaffiliated individual promoter who used YouTube to market the coin and earn money from followers who purchased BCC using his personal referral code.

Tezos – Between November and December 2017, five separate putative class actions were filed against Dynamic Ledger Solutions, Inc. (DLS), its founders and representatives, and its affiliate the Tezos Foundation, a Swiss nonprofit entity used to raise and manage the funds that would eventually be used to purchase DLS once it developed and launched the Tezos network. In exchange for “donations” of cryptocurrencies, early adopters would receive a claim to a certain number of “Tezzies,” the proprietary Tezos cryptocurrency designed to ultimately rival Bitcoin and the Bitcoin network’s market dominance. Investors in the Tezos suits argue, among other things, that the “Tezzie” rights purchased in the ICO were actually unregistered securities, for which refunds and rescission are appropriate remedies in light of a number of failed promises made by DLS and the Tezos founders in anticipation of the token sale. In addition to claims rooted in securities laws, at least one of the suits (which has since settled) also asserted state law claims under consumer protection statutes barring unfair and deceptive trade practices.

Aside from the potentially novel securities law questions that produced and remain central to these suits, the BitConnect and Tezos lawsuits highlight a number of other independent concerns—both legal and practical—for companies raising capital through digital/crypto-asset sales:

  • Class action waiver provisions and choice-of-law provisions, to the extent valid at all, may have little practical impact on legal expenditures – A notable feature of the Tezos litigation—which has spawned more class suits than any other ICO—are the provisions in its “donation” agreements requiring waiver of the donor’s right to bring a class action suit, as well as clauses requiring the application of Swiss law (in the “ordinary courts” of Zug, Switzerland). Whatever the ultimate merits, these provisions have had little practical impact on the course of litigation to date, and they are not a reliable means for eliminating or, for that matter, mitigating, short-term legal expenditures.
  • Boilerplate investment risk disclosures are unlikely to affect contract- and fraud-based claims – In the Kentucky BitConnect litigation, plaintiffs note in their complaint that the company’s generic warnings and risk disclosures failed to account for the ultimate sources of their losses: alleged concealment of key information about the internal mechanisms of the company and broken contractual promises to maintain the company’s operations and trading platform. As in traditional consumer litigation, offerors can neither expect to rely on basic disclaimers regarding customers’ contractual rights and expectations nor contract around common law fraud.
  • Defending and/or complying with a preliminary injunction may be difficult, if not impossible, in some cases – Both the Tezos and BitConnect lawsuits have involved requests for temporary restraining orders (TRO), a procedural mechanism that can be used to freeze assets pending the outcome of the litigation. Plaintiffs were successful in their TRO request against BitConnect, where the court found that the plaintiffs were likely to succeed on the ultimate merits and had adequately demonstrated a threat of irreparable harm (notably characterizing BitConnect’s activities as, among other things, a “massive consumer fraud”). In its order, the court barred the defendants from moving assets without court approval and, in a novel twist, required the defendants to disclose all Bitcoin and other cryptocurrency wallet addresses, trading account addresses, and the identities of the holder/owner of any wallet or cryptocurrency addresses used to transfer Bitcoin or any other cryptocurrency in the past 90 days. The court’s disclosure requirements raise unique questions about the feasibility of monitoring compliance in the event that tokens are exchanged for “private” or untraceable cryptocurrencies, as well as the practicality of forcing defendants themselves to monitor and report financial activity. On a more conventional note, the threat of a TRO also poses a variety of accounting, recordkeeping, asset management and cash flow challenges for what ordinarily, at least in the case of ICO-based sales, will be a fledgling company that simply cannot afford to have its operating capital frozen.
  • Organizational distinctions or statements of nonaffiliation do not necessarily preclude liability or personal involvement in civil litigation – Among the novel aspects of the Tezos ICO was its use of a Swiss nonprofit entity to accept “donations” and manage funds while the founders centralized network development and engineering responsibilities in the independent entity, DLS. As evidenced by the long list of individual defendants thus far named in the litigation, legal and organizational divides are unlikely to deflect individual liability, or at least, individual involvement and reputational risk, in meaningful ways.

To be sure, all of these issues are, by definition, subject to litigation and, in many cases, may well be resolved in the defendant’s favor (as noted, at least one of the Tezos class actions has settled, and the companies involved were ultimately successful in defending against the class plaintiffs’ request for a TRO). That said, companies and individuals considering a token sale or similar digital asset issuance as a means for raising funds should consider the broad range of substantive and procedural issues that can arise from private litigation, and plan their operations and budgeting accordingly to anticipate and mitigate (or even eliminate) these risks.