Kent v. Pooltogether, Inc.

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JOSEPH KENT, Plaintiff, v. POOLTOGETHER, INC.; DHARMA LABS, INC.; OZONE NETWORKS, INC.; LEIGHTON CUSACK; KAIN WARWICK; STANISLAV KULECHOV; DRAGONFLY DIGITAL MANAGEMENT, LLC; NASCENT US, LLC; NASCENT LIMITED PARTNERSHIP; STICHTING MAVEN 11 FUNDS; GALAXY DIGITAL TRADING HK LIMITED, LP; PARAFI CAPITAL, LP; and COMPOUND LABS, INC., Defendants.

No. 21-CV-6025-FB-CLP

United States District Court, E.D. New York

June 7, 2023

CHARLES GERSTEIN JAMES CROOKS

Gerstein Harrow LLP Fairmark Partners, LLP

JASON HARROW

Gerstein Harrow LLP

KEVIN P. BROUGHEL

Paul Hastings LLP

JOHN P. AMATO

ANDREW W. BLACKWELL

JASON GOTTLIEB

Morrison Cohen LLP

BRIAN E. KLEIN

Waymaker LLP

Galaxy Digital Trading HK Limited, LP,

and ParaFi Capital, LP:

SEAN HECKER

Kaplan Hecker & Fink LLP

MEMORANDUM AND ORDER

FREDERIC BLOCK, SENIOR UNITED STATES DISTRICT JUDGE

In this putative class action, Joseph Kent claims that he and thousands of others contributed cryptocurrency to an illegal lottery. He seeks to recover double the amount contributed, plus double his reasonable attorney's fees and costs, pursuant to New York law. Jurisdiction is premised on the Class Action Fairness Act of 2005, 28 U.S.C. § 1332(d).

All of the defendants who have appeared in the action have moved to dismiss pursuant to Federal Rules of Civil Procedure 12(b)(1) and 12(b)(6); two have moved, in the alternative, to compel arbitration. These motions present numerous issues, but the dispositive question is whether the plaintiff has alleged sufficient facts to establish his standing to sue under Article III. Having reviewed the parties' submissions and heard oral argument on that issue, the Court holds that he has not.

I

In 2019, Defendant Leighton Cusack and others wrote a piece of software (technically, a network protocol) for use on the Ethereum blockchain, a decentralized ledger of highly encrypted transactions involving various cryptocurrencies. The protocol-dubbed PoolTogether-allows the owners of these secure digital assets to make their holdings available to “liquidity pools” for various investments. These pools, in turn, use different protocols to lend out cryptocurrency at interest. One such protocol was developed by Compound Labs, Inc. (“Compound”). Compound, which promotes PoolTogether on its website, retains a portion of the interest earned as a fee and pays the rest to PoolTogether.

Contributors using the PoolTogether protocol do not receive that interest directly. Instead, they receive a “ticket” for every dollar's worth of cryptocurrency they contribute. PoolTogether then randomly selects a predetermined number of tickets and, after retaining a percentage of the interest received as a reserve, distributes the balance among the holders of the winning tickets.

In sum, contributors forgo a guaranteed interest rate in exchange for a chance at a greater return on their investment. Since its inception, PoolTogether has received about $122 million in contributions and paid approximately $4.3 million in prizes.

Contributions to PoolTogether may be withdrawn at any time. However, blockchains like Ethereum are labor- and resource-intensive. To recoup its operating costs, Ethereum charges what is colloquially referred to as a “gas fee” for every transaction. Such fees can be significant and only large contributions generate enough returns to offset them. To encourage smaller contributions, PoolTogether allows users to pool their contributions into “pods” that share the gas fees (but also the potential winnings).

Arrangements like PoolTogether are often described as “no-loss lotteries” because the underlying contributions are not distributed to winners, as they are in a typical lottery. Rather, they are used to generate the investment income that funds the awards. In that sense, PoolTogether is akin to a “prize-linked savings account,” in which some of the interest earned is pooled and offered as chance-based prizes. But whereas such savings accounts are offered by financial institutions subject to federal and state oversight, PoolTogether is largely unregulated. Unlike a bank, for example, its deposits are not guaranteed by the Federal Deposit Insurance Corporation and there are no restrictions on the uses to which it can put the contributions it receives.

Cusack and the other developers of the PoolTogether protocol formed Defendant PoolTogether, Inc., in September 2019, but the corporation and the protocol remain separate entities. While PoolTogether, Inc., is run as a traditional corporation, the protocol itself is governed by a decentralized autonomous organization (“DAO”), which initially consisted of Cusack and his team, investors in PoolTogether, Inc., and early users of the protocol. In May 2021, Defendants Dragonfly Digital Management, LLC, Nascent US, LLC, Nascent Limited Partnership, Stichting Maven 11 Funds, Galaxy Digital Trading HK Limited, LP, and ParaFi Capital, LP (collectively, the “Investor Defendants”) acquired ownership “tokens” (apparently akin to shares of stock) in exchange for $5.95 million. According to the complaint, the DAO can “do with the protocol whatever a holder of a majority of tokens wish[es] to do.” Second Amended Complaint (“SAC”) ¶ 56.

Contributors can access PoolTogether on a website and through various smartphone apps. Defendant Dharma Labs, Inc. (“Dharma”), operated one such app, which prominently advertised PoolTogether. Although it charged its own user fees, Dharma could offer discounted “gas fees” by executing transactions collectively. In January 2022, Dharma was acquired by Defendant Ozone Networks, Inc.

Plaintiff Joseph Kent is “gravely concerned that the cryptocurrency ecosystem-which requires the use of enormous amounts of electricity-is accelerating climate change and allowing people to evade financial regulations and scam consumers.” SAC ¶ 4. He nevertheless chose to participate in that ecosystem. On October 21, 2021, Kent visited the website “app.pooltogether.com” and delivered ten dollars' worth of cryptocurrency to the protocol. In exchange, he received 10 tickets for a PoolTogether lottery with a prize of $778 and odds of 1:2,303. The transaction incurred a “gas fee” of $265.60.

On January 17, 2022, Kent used the Dharma app to deliver another two dollars' worth of cryptocurrency to PoolTogether in exchange for two tickets in another lottery. The complaint does not allege the prize or odds of that lottery but the transaction incurred a “gas fee” of $99.87 and a user fee of $2.70.

II

The complaint frankly admits that Kent's main objections to PoolTogether are its environmental impact and lack of regulatory oversight. His lawsuit however, is based on an entirely different premise. Under New York law, “[a]ny person who shall purchase any share, interest, ticket, certificate of any share or interest, or part of a ticket, or any paper or instrument purporting to be a ticket or share or interest . . . in any portion of any lottery, may sue for and recover double the sum of money, and double the value of goods or things in action, which he may have paid or delivered in consideration of such purchase, with double costs of suit.” N.Y. Gen. Oblig. L. § 5-423. “Any person who shall have paid any money, or valuable thing, for a chance or interest in any lottery or distribution, prohibited by the penal law, may sue for and recover the same of the person to whom such payment or delivery was made.” Id.

Invoking that statute, Kent demands-on behalf of himself and a proposed class of thousands of other contributors to the PoolTogether protocol-“[a]n award of compensatory damages against all Defendants jointly and severally in the amount of double the value of cryptocurrency that the class[ ]members delivered to PoolTogether or the PoolTogether protocol,” plus “double the amount of reasonable attorneys' fees and costs of this Action.” SAC Prayer for Relief.

Thus, the central question on the merits of this lawsuit is whether the PoolTogether protocol constitutes an illegal lottery. The defendants' motions to dismiss raise other ancillary issues, such as who is liable for a violation of the statute and whether the statute contemplates secondary liability for aiding and abetting or conspiracy. Those questions are thorny and unanswered, and should probably be resolved by the New York Court of Appeals.

But before the Court can even consider those questions, it must address its subject-matter jurisdiction. “For a court to pronounce upon the meaning . . . of a state or federal law when it has no jurisdiction to do so is, by very definition, for a court to act ultra vires.” Steel Co. v. Citizens for a Better Env't, 523 U.S. 83, 101-02 (1998). In that regard, all of the moving defendants challenge Kent's standing to sue.^[1]

Under Article III of the Constitution, federal courts have subject-matter jurisdiction over only “Cases” and “Controversies.” “One element of the case-or-controversy requirement is that [plaintiffs], based on their complaint, must establish that they have standing to sue.” Raines v. Byrd, 521 U.S. 811, 818 (1997) (citing Lujan v. Defenders of Wildlife, 504 U.S. 555, 561 (1992)).

“[T]o establish standing, a plaintiff must show (i) that he suffered an injury in fact that is concrete, particularized, and actual or imminent; (ii) that the injury was likely caused by the defendant; and (iii) that the injury would likely be redressed by judicial relief.” TransUnion LLC v. Ramirez, 141 S.Ct. 2190, 2203 (2021) (citing Lujan, 504 U.S. at 560-61). “Where, as here, a case is at the pleading stage, the plaintiff must clearly allege facts demonstrating each element.” Spokeo, Inc. v. Robins, 578 U.S. 330, 338 (2016).

A. Injury in Fact

Kent acknowledges that he voluntarily...