Recent Securities Class Actions Targeting ICOs Raise Variety of Complex Legal Issues

1On April 3, 2020, exactly one year after the Securities and Exchange Commission (SEC) issued its “Framework for ‘Investment Contracts’ Analysis of Digital Assets” (Framework), 11 class action lawsuits were filed in the Southern District of New York by two law firms representing various combinations of four proposed lead plaintiffs.1 The lawsuits all name as defendants companies and affiliated individuals involved in creating blockchain networks and platforms for various business activities that either distributed blockchain-based cryptographic assets (tokens) in initial coin offerings (ICOs) or operated trading platforms (exchanges) for the purchase and exchange of such tokens. The 11 complaints rely on the same essential legal theories — that the original token sales were unregistered securities offerings and the exchanges that facilitated secondary token sales were unlicensed securities dealers. In this article, we analyze these claims and discuss some of the potential defenses to them.21 Eric Lee and Chase Williams v. Binance Changpeng Zhao, Yi He, and Roger Wang (Case 1:20-cv-02803); Alexander Clifford and Chase Williams v. Tron Foundation, Justin Sun and Zhiqiang (Lucien) Chen (Case 1:20-cv-02804); Chase Williams and William Zhang v. HDR Global Trading Limited, ABS Global Trading, Arthur Hayes, Ben Delo and Samuel Reed (Case 1:20-cv-02805); Chase Williams v. Kucoin, Michael Gan, Johnny Lyu, and Eric Don (Case 1:20-cv-02806); Alexander Clifford v. Bibox Group Holdings Limited, Bibox Technology Ltd., Bibox Technology Ou, Wanlin “Aries” Wang, Ji “Kevin” Ma, Jeffrey Lei (Case 1:20-cv-02807); Chase Williams and William Zhang v. Block.One, Brendan Blumer, and Dan Larimer (Case 1:20-cv-02809-LAK); William Zhang v. BProtocol Foundation, Eyal Hertzog, Yehuda Levi, Guy Benartzi, and Galia Benartzi (Case 1:20-cv-02810); William Zhang v. Civic Technologies, Inc., Vinny Lingham, and Jonathan Smith (Case 1:20-cv-02811); Alexander Clifford v. Kaydex Pte. Ltd., Loi Luu, Victor Tran, and Yaron Velner (Case 1:20-cv-02812); Chase Williams v. Quantstamp, Inc., Richard Ma, and Steven Stewart (Case 1:20-cv-02813); Alexander Clifford v. Status Research & Development GMBH, Jarrad Hope, and Carl Bennetts (Case 1:20-cv-02815).2 While the cases discussed here involve private actions, we believe it is important to note for our audience that the SEC has cautioned that most (if not all) fundraising events commonly known as “ICOs” are securities offerings that need to be registered with the SEC or fall under an exemption from registration. For example, in a speech on April 26, 2018, SEC Chairman Jay Clayton commented that with regard to “tokens which are used to finance projects … [t]here are none that I’ve seen that are not securities.” Summary of the Claims and Key DefensesThe actions filed are mostly against foreign entities and their founders living abroad that raised funds in 2017 through ICOs or that listed these ICO tokens on foreign cryptocurrency exchanges. The ICOs were sold internationally and purportedly specifically not to U.S. persons, but the complaints allege some sales activity occurred in the U.S. The actions allege that these ICOs were unregistered securities offerings under the federal securities laws, and some of the actions allege that the exchanges that supported the tokens were unregistered broker-dealers and/or exchanges. All the actions make federal claims under Section 12(a)(1) of the Securities Act of 1933 (Securities Act) for violations of the registration provisions of Section 5 of the Securities Act. Section 5 makes it unlawful to make a nonexempt offer and sale of securities without filing a registration statement with the SEC. The actions also allege violations of related state blue sky laws. The plaintiffs also allege control person liability claims under Section 15(a) of the Securities Act against the founders and/or managers of the defendant companies. The class periods and members in all the lawsuits are not limited to the time period when the funds were initially raised in ICOs. Rather, the complaints allege that the tokens offered in the ICOs were thereafter traded on exchanges, and they rely on this ongoing activity to seek class certification for the entire periods from the ICOs through the present. The complaints are likely to be contested on a number of alternative grounds. First, the defendants may argue that the claims should fail for missing the one-year statute of limitations applicable to Section 12(a)(1) claims. The defendants will likely argue that the plaintiffs’ allegations that investors did not know until the issuance of the Framework that the tokens at issue in the various actions were securities is inconsistent with the considerable record of prior pronouncements and enforcement actions by the SEC. Recent Securities Class Actions Targeting ICOs Raise Variety of Complex Legal IssuesMarc D. Powers, Robert A. Musiala Jr. and Matthew Friedman*This article first appeared in the BlockTribune on August 5, 2020. 22The defendants may also challenge the allegation that the public offering through token sales on exchanges is still continuing almost three years after the initial ICO. Second, the defendants will likely raise the question of whether the Southern District of New York has proper personal jurisdiction over either the companies that sold the tokens or the founders, many of whom never visited the United States for the ICO and never used domestic intermediaries to facilitate the sales. The Supreme Court decision in Morrison v. Australia National Bank, which addressed the extraterritorial reach of Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act), may also be raised as a defense to several of these actions. In addition, the defendants may argue lack of subject matter jurisdiction by asserting that the tokens sold should not be deemed “investment contracts,” and therefore are not “securities,” under the federal securities laws. If the tokens are not securities, there is no jurisdiction for the federal court, and no basis for it to retain supplemental jurisdiction for the state blue sky law claims. Third, the defendants may challenge the proposed class plaintiffs, and allegations for class certification, as inadequate. Certifications for complaints required by the Public Securities Litigation Reform Act often lack the ordinary detail of when the proposed lead plaintiff purchased the token/security, where it was purchased and for how much. They often rely on the conclusory allegation that the purchases were made by the plaintiffs during the class period. It should matter whether the purchases were made during the ICO or on a cryptocurrency exchange, as there is a “seller” requirement for liability under Section 12(a)(1). If the purchases were made after the ICO period, the defendants may argue that the plaintiff is not an adequate class representative. The defendants may also argue that there is a lack of adequate Article III standing, or injury, for the proposed lead plaintiff to invoke the jurisdiction of a federal court to hear the case. Finally, the defendants may raise questions as to whether the class is ascertainable. Statute of Limitations DefenseSection 13 of the Securities Act provides, “No action shall be maintained … to enforce a liability created under section [12(a)(1)], unless brought within one year after the violation upon which it is based.” 15 U.S.C. § 77m. In the context of these 11 litigations brought exactly one year from the issuance of the Framework, the question is whether the “violation upon which” the claim is based occurred before April 3, 2019. Case law interpreting the one-year limitation period for Section 12(a)(1) claims requires cases to be filed in federal court within one year after a reasonable investor would have been aware of the violation.3 The defendants will likely argue that there were events after the ICOs and before the April 3, 2019 publication of the Framework that would have put any reasonable purchaser on notice that the tokens would likely constitute “securities.” For example, the SEC issued the DAO Report in July 2017, the SEC brought enforcement actions 3 See Jackson Nat. Life Ins. v. Merrill Lynch (2d Cir. 1994); Finkel v. Stratton Corp. (2d Cir. 1992).against multiple ICOs, and key SEC commissioners and officials gave public speeches throughout 2017 and 2018 expressing their views that most ICOs were unregistered securities offerings. Based on these events, the defendants might argue that if a purchaser participated in an ICO shortly after the creation of the Ethereum network, he or she was likely sophisticated enough in this area to be aware of the SEC’s stance on ERC20 tokens articulated in the DAO Report and in the multiple enforcement actions that were underway and well publicized before the Framework was issued. The plaintiffs have at least two potential answers to the statute of limitations defense. First, courts in some federal jurisdictions have extended the one-year limitations period on the basis of equitable tolling or equitable estoppel. While these doctrines are disfavored in securities cases, plaintiffs who allege a form of “misleading” conduct may gain the benefit of a toll.Second, plaintiffs may argue that the unregistered securities offering continued while tokens traded on foreign exchanges. This argument has found some support in the Northern District of California, in Zakinov v. Ripple Labs, Inc.4 In that case, there was no ICO and, as the court explicitly noted, the plaintiff “d[id] not specify whether he...