The Possible Regulatory Gap in Future ICO Class Action Litigation
Posted on Nov 18, 2020Reno Varghese
The Wild West days of cryptocurrencies ended abruptly on June 18, 2016. After an otherwise successful crowdfunding for DAO, which raised over $150 million from 11,000 investors[1], an unknown attacker managed to drain over 3.6 million ether, valued at about $50 million, from DAO, dropping the worldwide price of ether[2] 35% in a single day.[3] Responding to the chaos, the Securities and Exchange Commission (“SEC”) indicated it would open its first significant cryptocurrency action. One year later, the SEC issued its “DAO Report,”[4] which found that DAO was indeed an unregistered security offering and that the SEC would begin to prosecute other token offerings in the future.[5] The SEC ultimately chose not to prosecute Slock.it, the firm responsible for the offer and sale of DAO tokens. Projects like Ethereum, which held an ICO prior to the DAO Report, would be grandfathered in. Future projects would undergo SEC scrutiny.[6]
The SEC’s 2017 memo has potentially far-reaching implications for plaintiffs bringing Rule 10b-5 class action lawsuits against ICO offerors. As of October 31, 2020, there has been one[7] Rule 10b-5[8] case against an Initial Coin Offering (“ICO”) offeror.[9] Generally though, the SEC and class action plaintiffs have chosen to sue offerors for issuing unregistered securities.[10] However, as most ICOs have proven to be fraudulent[11] and the SEC has clarified its ICO regulation guidance[12], some ICO offerors now appear to be registering their offerings with the SEC.[13]
With increased registration and regulation, ICO offerors will become liable for misstatements and omissions in their registration documents, similar to any other organization that places securities in the market.[14] For Rule 10b-5 cases, a plaintiff must prove that she relied on the issuer’s misstatement or omission. Since proving reliance on a class-wide basis is quite tricky, courts have allowed plaintiff classes to apply the Fraud on the Market (“FOTM”) theory to presume reliance under a set of specific conditions. Unfortunately, due to critical differences between the ICO market and the general securities market, the FOTM presumption is not available to plaintiff classes in the ICO context.
The Supreme Court constructed FOTM theory and allowed its use in Rule 10b-5 litigation because proving individual reliance in a class action security case is next to impossible.[15] Investors trade for all sorts of different reasons, whether because the stock price is moving up, they like the name of the stock ticker[16], or for any other number of irrational reasons.[17] Because proving individualized reliance is impossible, courts have essentially constructed a fiction that all traders are momentum traders.[18] Plaintiffs are permitted to plead that they bought the security because the price went up: the inflated price due to fraud modified the market. For that reason, if the defendant can show there was no price movement, the defendant can successfully defeat FOTM reliance.[19]
However, this constructive fiction requires that the security traded in an efficient market. Thus, plaintiffs in cases involving securities purchased on inefficient primary markets cannot apply the FOTM presumption of reliance. As Professor John Coffee, an expert in securities litigation at Columbia Law School, has noted, FOTM theory is oddly under-inclusive for an approach that is intended to be plaintiff-friendly: “in areas where a fraud remedy is most needed (for example, in “pump and dump” and similar cases involving OTC stocks and the lower rungs of Nasdaq), class certification will be generally unavailable on the grounds that the market is not efficient, even though price distortion may seem clear.”[20]
There is a wealth of evidence indicating that cryptocurrency markets fall into this gap in the FOTM theory. Most evidence suggests that cryptocurrency markets are not efficient[21], or if they are efficient, it takes ample liquidity and time to create market efficiency.[22] While the evidence is mixed on the exact reasons or how to generate efficiency in these markets, there are a few takeaways. First, due to the nature of the incipient markets, ICOs are likely inefficient at inception and for a while afterward.[23] Evidence for this theory can be seen in the number of ICOs that go bankrupt or are declared fraudulent soon after formation.[24]
Second, while cryptocurrency markets such as Bitcoin and Ethereum have become efficient in time[25], not even the most successful ICOs were efficient during their initial ICO stage.[26] Consequently, there appears to be a gap in the regulation of these inefficient primary market transactions. Notably, while this gap may also exist for IPOs[27], investors harmed in a fraudulent IPO can fall back on Section 11 protections[28], which ICO participants could not avail themselves to.[29] Finally, even if ICOs fully comply with current SEC registration requirements, the requirements themselves may not require enough information to be disclosed about “token valuation and pricing” to not “cripple market efficiency.”[30]
Courts can solve the gap in the regulatory framework for ICOs in two ways. First, courts could extend the constructive fiction that primary markets are efficient to ICOs. This approach would align with court decisions rejecting the FOTM hypothesis. In primary markets, investors who want to sue fraudulent business enterprises must search for isolated misstatements and hope the court largely ignores the market efficiency market question.[31] Alternatively, courts could declare that anyone that invests in an ICO understands the risks associated with such an enterprise and cannot recover damages through Rule 10b-5. While this would lower the chance that courts would turn the firm into an insurer ex-post sale, it also seems to cut against the SEC’s desire to establish rules on the ICO marketplace and protect investors. Otherwise, the SEC could have simply washed its hands of the unregulated ICO marketplace and not brought any securities fraud cases.[32] Unfortunately, neither of these solutions seems ideal. The first solution seems to leave too much discretion to the trial judge, and the latter prevents defrauded investors from claiming any recovery on a class basis. For a fairer process, courts may have to recognize a new theory of reliance in the ICO context.
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[1] This was at the time the largest crowdfunding in history. David Siegel, Understanding the DAO Attack, Coindesk (Nov. 13, 2020), https://www.coindesk.com/understanding-dao-hack-journalists.
[2] Ether is a type of cryptocurrency. Ethereum, Coindesk, https://www.coindesk.com/price/ethereum.
[3] David Siegel, Understanding the DAO Attack, Coindesk (Nov. 13, 2020), https://www.coindesk.com/understanding-dao-hack-journalists; Nathaniel Popper, A Hacking of More than $50 Million Dashes Hopes in the World of Virtual Currency, N.Y. Times, Jun. 17, 2016, https://www.nytimes.com/2016/06/18/business/dealbook/hacker-may-have-removed-more-than-50-million-from-experimental-cybercurrency-project.html.
[4] U.S. Securities and Exchange Commission, Release No. 81207 – Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Jul. 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf.
[5] U.S. Securities and Exchange Commission, Release No. 81207 – Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Jul. 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf.
[6] Kollen Post, The Death of the ICO: Has the US SEC Closed the Global Window on New Tokens?, CoinTelegraph (May 23, 2020), https://cointelegraph.com/news/the-death-of-the-ico-has-the-us-sec-closed-the-global-window-on-new-tokens.
[7] There is one case where plaintiffs have alleged a violation of Section 10b and attempted to certify a class for a Rule 10b-5 class action. However, the primary allegation is that the defendants sold plaintiffs shares in a Ponzi scheme, where the defendants paid plaintiffs their returns using the money obtained from other investors in a fraudulent scheme. No documents related to the cryptocurrency were filed with the SEC at any point. Litigation in the case is still ongoing. First Amended Complaint, Audet v. Fraser, (D. Conn. 2016) (No. 3:16-v-0940), http://securities.stanford.edu/filings-documents/1058/GML00_01/2016114_r01c_16CV00940.pdf.; Ruling on Class Certification, Audet v. Fraser, (D. Conn. 2019) (No. 3:16-v-0940), https://www.courthousenews.com/wp-content/uploads/2019/06/Cryptocurrency.pdf; see Case Summary – GAW Miners, LLC: Cryptocurrency Securities Litigation, Stanford Law School Securities Class Action Clearinghouse – A Collaboration with Cornerstone Research, http://securities.stanford.edu/filings-case.html?id=105843.
[8] In short, Rule 10b-5 class actions are a common source of shareholder lawsuits against public companies for misstatements and omissions made in their public disclosures. See Section 10(b) Litigation: The Current Landscape, American Bar Association (Oct. 20, 2014), https://www.americanbar.org/groups/business_law/publications/blt/2014/10/03_kasner/.
[9] See Stanford Law School Securities Class Action Clearinghouse – A Collaboration with Cornerstone Research, http://securities.stanford.edu/current-topics.html#collapse1.
[10] Stanford Law School Securities Class Action Clearinghouse – A Collaboration with Cornerstone Research, http://securities.stanford.edu/current-topics.html#collapse1.
[11] A 2018 report on the state of the cryptoasset industry indicated that while over 70% of ICO funding went toward high-quality projects, over 80% of ICOs were identified as scams. Sherwin Dowlat, Cryptoasset Market Coverage Initiation: Network Creation, Satis Group (Jul. 11, 2018), https://research.bloomberg.com/pub/res/d28giW28tf6G7T_Wr77aU0gDgFQ.
[12] U.S. Securities and Exchange Commission, Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.; See also, U.S. Securities and Exchange Commission, Release No. 81207 – Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Jul. 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf.
[13] See e.g., The Praetorian Group’s PAX Coin Is the First Cryptocurrency ICO to File with the U.S. Securities and Exchange Commission, PR Newswire (Mar. 12, 2018), https://www.prnewswire.com/news-releases/the-praetorian-groups-pax-coin-is-the-first-cryptocurrency-ico-to-file-with-the-us-securities--exchange-commission-300612419.html; Paul Vigna, SEC Clears Blockstack to Hold First Regulated Token Offering, Wall St. J., Jul. 10, 2019, https://www.wsj.com/articles/sec-clears-blockstack-to-hold-first-regulated-token-offering-11562794848; Alon Y. Kapen, First S-1 Filing for an ICO: Going Legit or Just a Crypto Head Fake?, Farrell Fritz (May 6, 2018), https://www.nyventurehub.com/2018/05/06/first-s-1-filing-for-an-ico-going-legit-or-just-a-crypto-head-fake/.
[14] See Section 10(b) Litigation: The Current Landscape, American Bar Association (Oct. 20, 2014), https://www.americanbar.org/groups/business_law/publications/blt/2014/10/03_kasner/.
[15] Basic Inc. v. Levinson, 485 U.S. 224, 242-47 (1988).
[16] Dan Horksy & Patrick Swyngedouw, Does It Pay to Change Your Company’s Name? A Stock Market Perspective, 6 Marketing Science 320 (1987) (finding that name changes are associated with improved stock performance).
[17] Evelyn Chang, $24 Million Iced Tea Company Says Its Pivoting to the Blockchain, and Its Stock Jumps 200%, CNBC (Dec. 21, 2017), https://www.cnbc.com/2017/12/21/long-island-iced-tea-micro-cap-adds-blockchain-to-name-and-stock-soars.html.
[18] Daniel Fisher, The Real Fraud is the Fraud on the Market Theory, Forbes (Mar. 3, 2014), https://www.forbes.com/sites/danielfisher/2014/03/03/the-real-fraud-is-the-fraud-on-the-market-theory/?sh=726c1fd234f7.
[19] Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258, 275 (2014).
[20] John C. Coffee, Jr., After the Fraud on the Market Doctrine: What Should Replace It?, The CLS Blue Sky Blog (Jan. 21, 2014), https://clsbluesky.law.columbia.edu/2014/01/21/after-the-fraud-on-the-market-doctrine-what-should-replace-it/.
[21] See e.g., Yang Hu et al., Market Efficiency of the Top Market-Cap Cryptocurrencies: Further Evidence from a Panel Framework, 31 Finance Research Letters 138 (2019), https://www.sciencedirect.com/science/article/pii/S154461231830610X; Andrew Urquhart, The Inefficiency of Bitcoin, 148 Economics Letters 80 (2016), https://www.sciencedirect.com/science/article/pii/S0165176516303640; David Vidal-Tomás & Ana Ibañez, Semi-strong Efficiency of Bitcoin, 27 Finance Research Letters 259 (2018), https://www.sciencedirect.com/science/article/pii/S1544612318300461; Ladislav Kristoufek & Miloslav Vosvrda, Cryptocurrencies Market Efficiency Ranking: Not so Straightforward, 531 Physica A: Statistical Mechanics and its Applications 1 (2019), https://www.sciencedirect.com/science/article/pii/S0378437119304558.
[22] See e.g., Ahihiko Noda, On the Evolution of Cryptocurrency Market Efficiency, Applied Economics Letters 1 (2020) (Ahead of Print), https://www.tandfonline.com/doi/epub/10.1080/13504851.2020.1758617?needAccess=true; Yuksel Iltas et al., Assessment of the Crypto Market Efficiency: Empirical Evidence from Unit Root Tests with Different Approximations, in Blockchain Economics and Financial Market Innovation 191-200 (Umit Hacioglu ed., 2019), https://link.springer.com/chapter/10.1007/978-3-030-25275-5_10;
[23] See Christian Fisch & Paul P. Momtaz, Institutional Investors and Post-ICO Performance: An Empirical Analysis of Investor Returns in Initial Coin Offerings (ICOs), 64 Journal of Corporate Finance 5 (2020), https://www.sciencedirect.com/science/article/pii/S0929119920301231: “While informational asymmetries cannot be exploited in efficient markets…we posit herein that the ICO market is a market in which institutional investors can extract informational rents (i.e., above-market returns)…[T]he ICO market is highly inefficient in that (most unsophisticated) investors are largely unable to see beyond ‘cheap-talk’ by ICO firms, and those inefficiencies vanish only gradually through information exchange in the aftermarket.”
[24] Sherwin Dowlat, Cryptoasset Market Coverage Initiation: Network Creation, Satis Group (Jul. 11, 2018), https://research.bloomberg.com/pub/res/d28giW28tf6G7T_Wr77aU0gDgFQ.
[25] Yuksel Iltas et al., Assessment of the Crypto Market Efficiency: Empirical Evidence from Unit Root Tests with Different Approximations, in Blockchain Economics and Financial Market Innovation 191-200 (Umit Hacioglu ed., 2019), https://link.springer.com/chapter/10.1007/978-3-030-25275-5_10.
[26] See Christian Fisch & Paul P. Momtaz, Institutional Investors and Post-ICO Performance: An Empirical Analysis of Investor Returns in Initial Coin Offerings (ICOs), 64 Journal of Corporate Finance 5-6 (2020), https://www.sciencedirect.com/science/article/pii/S0929119920301231
[27] John C. Coffee, Jr., After the Fraud on the Market Doctrine: What Should Replace It?, The CLS Blue Sky Blog (Jan. 21, 2014), https://clsbluesky.law.columbia.edu/2014/01/21/after-the-fraud-on-the-market-doctrine-what-should-replace-it/.
[28] Adam M. Apton, Pleading Section 11 Liability for Secondary Offerings, American Bar Association (Jan. 4, 2017), https://www.americanbar.org/groups/litigation/committees/securities/practice/2017/pleading-section-11-liability-for-secondary-offerings/.
[29] Section 11 only applies to present facts, not forward-looking statements. 15 U.S.C.A. § 77(k)(a). Unlike in regular public offerings, ICO whitepapers rely almost entirely on future projections to sell the project instead of historical data. See Chris Brummer et al., What Should be Disclosed in an Initial Coin Offering?, in Cryptoassets: Legal, Regulatory, and Monetary Perspectives 170-75 (Chris Brummer ed., 2019). See also, Daniel Kees, We Need to Talk About ICOs, The Regulatory Review (Sept. 26, 2019), https://www.theregreview.org/2019/09/26/kees-need-talk-about-icos/.
[30] Chris Brummer et al., What Should be Disclosed in an Initial Coin Offering?, in Cryptoassets: Legal, Regulatory, and Monetary Perspectives 158-59 (Chris Brummer ed., 2019). See also, Daniel Kees, We Need to Talk About ICOs, The Regulatory Review (Sept. 26, 2019), https://www.theregreview.org/2019/09/26/kees-need-talk-about-icos/.
[31] See Ann Lipton, Rumpelstiltskin and the Securities Laws, Law Professor Blogs Network (Jul. 25, 2020), https://lawprofessors.typepad.com/business_law/2020/07/rumpelstiltskin-and-the-securities-laws.html.
[32] While the SEC waited to regulate the market, it has begun to do so with great gusto. For a list of SEC cyber enforcement actions involving digital assets, see U.S. Securities and Exchange Commission, Cyber Enforcement Actions, https://www.sec.gov/spotlight/cybersecurity-enforcement-actions.