05 Mar 2024
With key district court decisions on predicate motions currently pending in S.E.C. v. Coinbase et al.,[i] and S.E.C. v. Binance Holdings Ltd. et al.,[ii] a brief look at U.S. caselaw assessing federal regulators’ claimed authority over the cryptocurrency landscape shows a lack of uniformity. To date, courts appear to be leaning toward finding that this landscape is governed by U.S. securities laws depending, of course, on the nature of the underlying product. However, on February 21, 2024, the Crypto Freedom Alliance of Texas and Lejilex, a digital asset company, filed suit against the Securities and Exchange Commission (SEC) in the Northern District of Texas asking the court to declare that secondary market digital assets are not sales of securities as defined by the Exchange Act and the Securities Act (“Lejilex”).[iii] Plaintiffs assert, in part, that the SEC has overstepped its regulatory authority over the industry without a clear statutory mandate. This article reviews representative cases addressing whether cryptocurrency falls within the U.S. securities framework under current analysis.
Claims in the cryptocurrency context arise not only from securities law but often involve multiple common law and statutory claims. By way of example, claims have been asserted against cryptocurrencies and exchanges under the Sherman Act, Commodities Exchange Act (CEA), Racketeer Influenced and Corrupt Organizations Act (RICO), as well as for common law fraud, conspiracy, conversion, and various tort claims.
As we’ll see shortly, courts typically apply the U.S. Supreme Court’s Howey test to determine whether an underlying cryptocurrency qualifies as a “security” under U.S. securities laws. Courts also come to different conclusions with some simply sidestepping the issue to dismiss on alternative grounds. In a 2023 proposed rule regarding “Safeguarding Advisory Client Assets,” the SEC acknowledged the “significant developments with respect to crypto assets” as well as digital assets such as “virtual currencies,” “coins,” and “tokens”. The SEC acknowledged that digital assets “may or may not meet the definition of a “security” under the Federal securities laws.”[iv]
The Howey Test
Whether an offering is an “investment contract” under the Securities Act is determined by the test set forth in S.E.C. v. W.J. Howey Co.[v] (“Howey”). Howey held that “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party” is an investment contract subject to regulation. The Howey test is intended to be “a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”[vi]
Cases dismissing claims involving digital assets
In Teed v. Chen[vii], the plaintiff sued for mismanagement of his Bitcoin, after transferring funds to Chen to invest and trade in Bitcoin via the Silverstream Opportunity Fund, LLC. The parties entered into an Investment Management Agreement (IMA) which allowed the plaintiff to withdraw assets within one day and provided that the plaintiff’s Bitcoin would not be transferred to any other account. Chen failed to pay the Bitcoin to the plaintiff after the IMA expired. The plaintiff sued, alleging violation of the Securities Act, among other causes of action. The court dismissed this count with leave to amend finding the plaintiff failed to plead the common enterprise element of the Howey test, as construed by the Ninth Circuit (i.e., the pooling of investments or that the parties’ fortunes were linked). The plaintiff amended the complaint and the court granted Chen’s motion to dismiss without leave to amend for failure to allege this same element.[viii]
In Underwood v. Coinbase Global Inc.,[ix] the court dismissed a putative class action filed by purchasers of various tokens against a centralized digital trading platform and its chief executive officer. The plaintiffs alleged violations of the Securities Act of 1933 (for the solicitation or sale of unregistered securities), the Securities Exchange Act of 1934 (for violation of registration requirements) and state law claims. There, the court bypassed the disputed issue as to whether the tokens constituted securities and assumed, for purposes of the motion, to dismiss that they did. But, it held the User Agreement terms specifically stated that title of the tokens would remain with the owner and did not transfer to Coinbase, thereby precluding any claim under the Securities Act.[x] The court also held the plaintiffs failed to plead any direct solicitation beyond collateral assistance necessary to support the registration claims.[xi] Further, because the Exchange Act claims were premised on the dismissed Securities Act claim, the control person allegations similarly failed. The court declined to exercise supplemental jurisdiction over the state law claims and dismissed the case with prejudice. The plaintiffs filed an appeal with the Second Circuit.[xii]
Though the cases we are about to look at demonstrate greater tendencies to finding the security element satisfied (at least preliminarily), the burden remains with the challenging party to prove it. For example, in United States v. Hampton[xiii], the defendants were indicted for allegedly manipulating the price of Hydrogen’s digital asset, “HYDRO.” The court granted the Government’s motion to exclude a professor’s expert testimony opining that “a reasonable person could not know whether HYDRO …constituted a security.”[xiv] The court found that a subjective belief as to the nature of the instrument would be irrelevant and, instead, the Government must prove that HYDRO was in fact a security.
Courts finding the Howey test satisfied
Other courts have determined the Howey test was sufficiently met to progress beyond the dismissal stage in a variety of contexts. See, for example:
Non-fungible tokens (NFTs) of professional basketball game moments recorded on private blockchain were investment contracts, noting “not all NFTs offered or sold by any company will constitute a security, and each scheme must be assessed on a case-by-case basis.”
Particularized allegations in multi-billion-dollar fraud claims alleged in the development, marketing and sale of cryptocurrency stablecoin tied to the U.S. dollar and companion exchange coin withstood motion to dismiss.
Cryptocurrency coin deemed “plausible” security on motion to dismiss.
Denying motion to dismiss class action against initial coin offering (ICO) to raise funds to create and launch new blockchain upon analysis of Howey factors.
Denying motion to dismiss and finding virtual currency was a commodity subject to Commodity Futures Trading Commission (CFTC) regulations.
On summary judgment, another court split on the issue after analysing the nature of the underlying transactions. The case in question was Securities Exch. Comm’n v. Ripple[xx] (“Ripple”). There, the court granted summary judgment in favour of the SEC as to sales to institutional investors of XRP tokens that were determined to be investment contracts. But, it also granted summary judgment to the defendants on programmatic sales of XRP through “blind bid/ask transactions” and as to other distributions for employee compensation or to third parties for development of new applications for the company’s ledgers.[xxi] The distinction focused on the third Howey factor, where the investment opportunity was highlighted to institutional investors versus the mere consumption by programmatic recipients. The court in Terraform Labs (see above), rejected the rationale adopted in Ripple that applied the Howey test differently to separate classes of purchasers.[xxii]
Generally, courts have been willing to find the elements of Howey met at least preliminarily with respect to a wide variety of digital assets. For example, see:
The court granted the plaintiffs’ motion for class certification, positing that cryptocurrency issued by the defendant was a “security” leaving ultimate determination for merits.
The court denied the blockchain development company’s motion to dismiss, finding the SEC sufficiently pled the common enterprise and expectation of profits elements based, in part, on the Supreme Court’s rejection of a narrow reading of the definition of securities.
The Howey test was met as the defendants’ website and Whitepaper’s invitation to purchase digital assets (BLV tokens) in return for digital currency satisfied the “investment money” prong (i.e. money pooled with a profit-sharing formula, and profits obtained from the managerial efforts of others), thereby granting the SEC’s request to preliminarily enjoin defendants from violating the Securities Act.
Finally, the Howey issue was essentially bypassed in Barron v. Helbiz, Inc. Here, the district court initially held the ICO satisfied Howey to meet the definition of “security” but the claims were nonetheless dismissed under the Supreme Court’s pronouncement in Morrison against the extraterritorial application of securities laws (i.e. “foreign cubed action”).[xxvi] Barron was reversed by the Second Circuit Court of Appeal.[xxvii] On remand, the district court reviewed some nineteen common law, state and federal statutory claims, finding some stated claims, including for Securities Exchange Act and Commodities Exchange Act violations, while others were subject to dismissal.[xxviii] Following its ruling and due to the “almost unmanageably complex” nature of the case, the district court certified the case to the Circuit Court on the following dispositive issue: whether the complaint alleged sufficient domesticity to avoid the bar that the matter is “so predominantly foreign as to be impermissibly extraterritorial.”[xxix]
The impact and consequences for arbitration
As cryptocurrency companies quickly pivot to include arbitration provisions in their agreements, these highlighted decisions, the pending Coinbase and Binance decisions, and, potentially the newly filed Lejilex challenge to the SEC’s authority, will inform the greater dispute resolution community.
The enforcement of arbitration agreements between private parties will be resolved at the outset of the case due to the Supreme Court’s recent resolution of the inter-circuit split, holding courts must stay litigation pending resolution of an appeal from a denial of a motion to compel arbitration.[xxx] That case happened to involve Coinbase, an online currency platform, but is relevant to denial of any motion to compel arbitration, each of which ultimately turn on the particular facts. For example, in Rensel v. Centra Tech, Inc.[xxxi], the court denied a motion to compel arbitration where an issue of fact remained as to whether the plaintiff had transacted via a smart contract (where there would be no consent to arbitrate) or through a clickwrap agreement (which would constitute consent to arbitrate).
An arbitral award involving cryptocurrency has already been confirmed in GBM Global Hold. Co., Ltd. v. 91 Individuals Attached to Schedule A[xxxii]. There, the tribunal awarded more than $5 million against 91 defaulting respondents arising from an alleged cyberattack orchestrated to obtain tokens through sham transactions and traded for other cryptocurrency, some frozen midstream by the suspecting cryptocurrency exchange.
Finally, confidentiality in cryptocurrency arbitration cannot be presumed. One notable institution was compelled to provide records of any pending arbitrations involving certain cryptocurrency platforms or certain defendants where they were determined to be relevant to a misappropriation claim arising from an attempt to broker a Bitcoin purchase.[xxxiii]
Perhaps the forthcoming Binance and Coinbase decisions will lend additional insight to these issues, but, no doubt, Circuit Courts must weigh in to achieve greater clarity to define the contours of when cryptocurrency is subject to U.S. securities laws.
About the authors:
Katherine Smith Dedrick JD MBA FCIArb is an attorney, consultant and independent arbitrator with 30+ years of experience in domestic and commercial contract and insurance coverage disputes, litigation and arbitration. She sits as a sole and panel arbitrator in disputes involving finance, construction, insurance, commerce, and others. She co-founded a disaster response and insurance consulting company based in the US and Asia Pacific (sold in 2017). She is the immediate past Chair of the Ciarb North America Branch and currently sits on its Board. Katherine is a panel member of the Singapore International Arbitration Centre and the Vancouver International Arbitration Centre, as well as AAA and FINRA. She is based in Denver, Colorado.
Ava Borrasso C.Arb FCIArb is an independent arbitrator and dispute resolution lawyer whose practice is built on 30+ years of experience in international commercial arbitration and litigation. She sits as emergency, chair, sole and panel arbitrator in disputes involving international commerce, financial services, trade and construction and is listed on the roster of many arbitral institutions. She sits on Board of the Ciarb North America Branch and serves as a Director of the Miami International Arbitration Society (MIAS). She is based in Miami, Florida.
[i] No. 1:23-cv-04738-KPF (S.D.N.Y.) (motion for judgment on the pleadings converted from motion to dismiss pending).
[ii] No. 1:23-cv-01588 (D.D.C.) (motion to dismiss pending).
[iii] No. 4:24-cv-00168-O, filed Feb. 21, 2024.
[iv] Securities & Exchange Comm., Release No. IA-6240, at 16 n. 25 (Feb. 15, 2023) (internal citations omitted).
[v] S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946)
[vi] Id. at 299 (holding citrus farmland sale and service contracts constituted investment contracts under the Securities Act of 1933).
[vii] Teed v. Chen, No. 22-cv-02862-CRB, 2022 WL 16839496 at *12 (N.D. Cal. Nov. 9, 2022)
[viii] Teed v. Chen, No. 22-cv-02862-CRB, 2023 WL 2277104 at *7 (N.D. Cal. Feb. 28, 2023) (while plaintiff alleged that defendant pooled monies together, no facts were alleged that profits were split or that fortunes were linked, thus failing to plead an “investment contract” under the Securities Act).
[ix] 654 F. Supp. 3d 224 (S.D.N.Y 2023).
[x] Id. at 236. Accord, Risley v. Universal Navigation Inc., __ F. Supp. 3d ___; 2023 WL 5609200 at *11, 17, 19 (S.D.N.Y. Aug. 29, 2023) (assuming arguendo that tokens were securities, traders’ putative class action against online interface operator used to access decentralized cryptocurrency exchange and exchange arising from scam tokens exchanged with unknown issuers dismissed for failure to allege claim arising from self-executing smart contracts, absence of transfer of title from defendants and lack of defendants’ solicitation of transactions) appeal filed, No. 23-1340, 2023 WL 5609200 (2d Cir. Sept. 28, 2023).
[xi] Underwood, 654 F. Supp. 3d at 237.
[xii] See Underwood v. Coinbase Global Inc., appeal docketed, No. 23-184 (2d Cir. Feb 9, 2023).
[xiii] United States v. Hampton, No. 23-CR-20172-KMW-2, 2024 WL 307641 (S.D. Fla. Jan. 26, 2024)
[xiv] Id at *1.
[xv] Friel v. Dapper Labs, Inc., 657 F. Supp. 3d 422, 450 (S.D.N.Y. 2023)
[xvi] Securities Exch. Comm’n v. Terraform Labs Pte Ltd., No. 23-cv-1346 (JSR), 2023 WL 4858299 at *1, 10, 14 (S.D.N.Y. July 31, 2023)
[xvii] De Ford v. Koutoulas, No. 6:22-cv-652-PGB-DCI, 2023 WL 2709816 at *15 (M.D. Fla. Mar. 30, 2023)
[xviii] Balestra v. ATBCOIN LLC, 380 F. Supp. 3d 340, 357 (S.D.N.Y. 2019)
[xix] Commodity Futures Trading Comm’n v. McDonnell, 287 F. Supp. 3d 213, 228 (E.D.N.Y. 2018)
[xx] Securities Exch. Comm’n v. Ripple, __ F. Supp. 3d __, 2023 WL 4507900, at *11, 13, (S.D.N.Y. 2023)
[xxi] Id. mtn. for cert. denied, No. 20 Civ. 10832 (AT), 2023 WL 6445969 (S.D.N.Y. Oct. 3, 2023).
[xxii] See Terraform Labs, 2023 WL 4858299 at *15.
[xxiii] Zakinov v. Ripple Labs., No. 18-cv-06753-PJH, 2023 WL 430364 at *4 (N.D. Cal. June 30, 2023)
[xxiv] Sec. & Exch. Comm'n v. NAC Found., LLC, 512 F. Supp. 3d 988, 996-97 (N.D. Cal. 2021)
[xxv] Sec. & Exch. Comm'n v. Blockvest, LLC, No.: 18CV2287-GPB(BLM), 2019 WL 625163, at *9 (S.D. Cal. Feb. 14, 2019)
[xxvi] Morrison v. National Australia Bank Ltd., 561 U.S. 247, 273 (2010) (rejecting extraterritorial application of Exchange Act §10(b) to “foreign cubed” cases – filed by foreign plaintiff against foreign issuer involving transaction in foreign country).
[xxvii]Barron v. Helbiz, Inc., No. 20 Civ. 4703(LLS), 2021 WL 229609 at *4, 6 (S.D.N.Y. Jan. 22, 2021) rev’d and remanded, Barron v. Helbiz, Inc., No. 21-278, 2021 WL 4519887 at *4 (2d Cir. Oct. 4, 2021).
[xxviii] Barron v. Helbiz, Inc., No. 20 Civ. 04703(LLS), 2023 WL 5672640 at *19-20 (S.D.N.Y. Sept. 2, 2023).
[xxix] Id. at 2023 WL 8622204 *1, 2 (S.D.N.Y. Dec. 13, 2023). Briefing before the Second Circuit is ongoing. Barron v. Micromobility.com Inc., No. 24-36, 2023 WL 5672640 (2d Cir. Jan. 4, 2024).
[xxx] Coinbase, Inc. v Bielski, 599 U.S. 736, 747 (2023).
[xxxi] Rensel v. Centra Tech, Inc., No. 17-245000-CIV-KING/SIMONTON, 2018 WL 4410110, at *14 (S.D. Fla. 2018)
[xxxii] GBM Global Hold. Co., Ltd. v. 91 Individuals Attached to Schedule A, No. 21 Civ. 6284 (AKH), 2022 WL 2713542, at *2 (S.D.N.Y. July 13, 2022)
[xxxiii] Symphony FS Ltd. v. Thompson, No. 5:18-cv-3904, 2018 WL 5023638, at *1 (E.D. Pa. 2018) (denying motion to quash subpoena to JAMS where its rules provided proceedings were confidential “unless otherwise required by law or judicial decision”).