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.
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.
Francisco J. Barreto, Esq.
100 SE 2nd Street, Suite 3105
Miami, Florida 33131