A rose by any other name might still be a security — another cryptocurrency class action lawsuit alleges securities laws violations and will force courts to provide guidance



May 29, 2018

Commercial Litigation Alert

Author(s): Daniel McAvoy

Another class action lawsuit, this time filed in California state courts, against Ripple alleges that XRP should be treated like a security. This alert discusses the plaintiff’s allegations and the lawsuit’s potential impact on ICOs and similar litigation.

Introduction

America’s chief securities regulator, the U.S. Securities and Exchange Commission (the “SEC”), has long asserted that virtual assets sold in an initial coin offering, or ICO, are securities under the U.S. Securities Act of 1933 (the “Securities Act”) and other federal securities laws. We continue to await interpretations from courts as to whether virtual assets will be treated as securities, and if so, which types of cryptocurrencies, utility tokens and other virtual assets might be treated as a security versus a currency or a commodity. Lawmakers, regulators and courts famously trail when responding to new technologies, and the uncertainty with cryptocurrencies is no exception. As we wait legislative determinations regarding the treatment of these new asset classes, lawsuits may force the courts to provide some guidance.

In our last alert, we analyzed a putative class action filed in the Eastern District of New York, brought under the Securities Act and seeking the unusual remedy of requiring the cryptocurrency company to retroactively create a fork before the digital assets were “lost.” Another prominent lawsuit filed in California Superior Court on May 3, 2018, may also force judicial guidance.

What happened

On May 3, 2018, Ryan Coffey brought a class action lawsuit against Ripple Labs, XRP and Ripple’s CEO, Brad Garlinghouse alleging violations of Sections 5, 12(a)(1) and 15 of the Securities Act, and the parallel California Corporations Code violations. See Coffey v. Ripple Labs, Inc, et al., CGC-18-566271 (Superior Court of California filed May 3, 2018). The claims arise out of the sale of XRP to the public in what Coffey calls “a never-ending initial coin offering (ICO).” A total of 100 billion XRP were created by Ripple at its inception in 2013. According to the class action complaint, 20 billion XRP (20% of the total XRP supply) were given to the individual founders of Ripple with the remaining 80 billion XRP (80% of the total XRP supply) being retained by Ripple to sell to secure funds to be used for “company operations and [to] improve the XRP Ledger.” Interestingly, the complaint distinguishes XRP from cryptocurrencies “such as Bitcoin and Ethereum, which are mined by those validating transactions on their networks,” because “all 100 billion of the XRP in existence were created out of thin air by Ripple Labs at its inception in 2013.” Starting in 2013, Ripple began selling XRP to the general public, decreasing the number held by Ripple to 67.51 billion XRP at the end of June 2015. Coffey alleges that Ripple’s primary source of income is through the sale of XRP, “which costs [d]efendants nothing since they created it out of thin air.”

Coffey alleges that he purchased 650 XRP on January 5, 2018, at a price of $2.60, paying a total of $1,690. He sold 649.98 XRP on January 18, 2018, at a price of $1.70, receiving a total of $1,104 U.S. Dollar Tether (which is a cryptocurrency purportedly backed by the U.S. dollar). The class action complaint provides that 1 USDT = about $1.03 on January 18, 2018, meaning that Coffey received $1,138.15 ($1.104.96*1.03) in exchange for the XRP he sold, “sustaining a loss of approximately $551.89, or over 32% his initial investment.”

Coffey focuses on statements made by Ripple to blur the lines between Ripple Labs’ enterprise management business and XRP (which does not entitle its holders to profits or other rights relating to that business), efforts made by Ripple to list XRP on Coinbase and Gemini to increase the perceived value of XRP and limiting the supply of XRP available to the public to drive up prices. It also distinguishes Ripple’s blockchain ledger from other “proof-of-work” distributed ledgers, alleging that Ripple’s maintenance of its own ledger through trusted nodes is greater evidence of a common enterprise than traditional cryptocurrency blockchains.

Coffey claims that XRP’s purchasers provided consideration in the form of fiat currency (such as U.S. dollars) or other cryptocurrencies in exchange for XRP, in a common enterprise and expected to profit from their ownership of XRP through the efforts of Ripple Labs and others. This effectively alleged that XRP meets all of the prongs of the “Howey” test for determining whether an instrument is an investment contract that is a security under the Securities Act. According to the class action complaint, Ripple and XRP violated the Securities Act by failing to register the offering of XRP with the SEC or with any state governmental entity, or to qualify from applicable exemptions therefrom.

Coffey seeks, among other things, rescission of his purchase price, compensatory damages, an accounting of remaining assets and funds raised by Ripple through the sale of XRP, to impose a constructive trust over those assets or funds, punitive damages and attorneys’ fees.

Implications

Court cases that challenge the categorization of cryptocurrencies as securities are under significant scrutiny from lawyers, cryptocurrency companies, regulators and the interested public in general. If courts identify cryptocurrencies as securities, coin offerings would be subject to the same procedures and regulations as initial public offerings of securities, which come with regulatory hurdles. While a number of ICOs have attempted to comply with exemptions from securities offering laws, such as through Regulation A+, Rule 506(c) and Regulation CF (securities crowdfunding), we still have yet to see a registered offering of a security token.

A determination that XRP is a security could lead to a spate of class action lawsuits seeking a right of rescission. Federal laws, as well as the laws of most states, provide that an offer and sale of securities in violation of securities laws entitle the holder to a right of rescission where the holder would be entitled to receive its purchase price, net of any subsequent sales price, plus the applicable statutory interest mandated under state law. The statutes of interests under rescission laws vary significantly, with some jurisdictions permitting claims only for a certain time period after sale and others permitting claims within a certain time period after discovery of the securities law violation. This means that plaintiffs may be able to bring rescission claims in certain states long after the initial issuance of the virtual assets to purchasers in those states. While the holders of securities often do not get much in return from a rescission claim, this type of action can be lucrative to securities class action lawyers if and when attorneys’ fees are awarded. If XRP is found to be a security, then a great many ICOs could be subject to rescission, as most early ICOs were not conducted in compliance with state and federal securities laws and many of them offered inadequate or minimal disclosure.

This case highlights another aspect of interest in identifying damages. If the court awards attorneys’ fees similar to the types of fees awarded in federal class actions regarding disclosure deficiencies in mergers votes and tender offers, it is likely that more lawsuits of this type will be filed across the country. If it doesn’t, fewer claims of this type will be filed since rescission damages generally are limited to a return of funds plus the statutory interest. Plaintiffs may start asserting violations of Rule 10b-5 of the Securities Exchange Act of 1934, which prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security and, more importantly, prohibits making any untrue statement of a material fact or omitting to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading in connection with the offer or sale of a security. Although not explicitly alleged in the Coffey lawsuit, the class action complaint plays with the idea that Ripple and XRP acted in a manner that was not forthcoming, shying away from using the term fraudulent. 10b-5 violations, however, may be slightly more challenging as they require proof of scienter. Awaiting guidance from the courts on whether cryptocurrencies will be considered securities is just one piece of the larger picture. The next will be to see how [p]laintiffs adapt and what types of claims they file. One thing is clear—cryptocurrency companies should not be surprised to see litigation in connection with token sales.

Assuming Coffey is successful in his lawsuit and damages are awarded, the manner in which damages are paid out will also be of interest. It is uncertain whether damages would get paid in the currency in which the cryptocurrency was purchased or in the U.S. dollar functional equivalent. If damages are paid out in the U.S. dollar functional equivalent, then there is potential for litigation arbitrage because most virtual assets are purchased using virtual currencies as opposed to fiat currencies (i.e., purchasing XRP with Bitcoin as opposed to the dollar). For example, if someone bought 10,000 XRP for 1 Bitcoin and Bitcoin was worth $10,000 when the purchase was made, and XRP was valued at $1, what would constitute the amount for rescission? If the purchaser gets back dollars at the time of purchase, he or she would only get back $10,000 plus interest, even if the value of Bitcoin has changed. If the value of the XRP hasn’t changed, it would be in the purchaser’s best interest to take the rescission offer if the value of Bitcoin dropped, even though the dollar and the XRP values stayed the same. However, if the value of Bitcoin increased to anything more than $10,000, it would be in the purchaser’s interest to seek rescission in the form of Bitcoin as 1 Bitcoin is worth more now than when the purchaser used it to buy XRP. On the other hand, if damages are paid in Bitcoin, it would be as if the purchaser had been invested in Bitcoin but was unable to sell during the period he or she held the XRP until the rescission is effected. In either case, there may be times when the plaintiff would not be entitled to the most equitable remedy, particularly when a virtual asset has been purchased using multiple cryptocurrencies.

We note that this case was brought at the California state court level. Thus, any decisions rendered in this case would not serve as precedent for federal cases or cases brought in the courts of other states. That said, given how broadly ICOs generally have been marketed, an enterprising plaintiff’s class action attorney should be able to locate a purchaser in California to establish a cause of action there. Further, other courts may still use this court’s analysis as a baseline for its own analysis of the treatment of virtual assets under their applicable securities laws.

Nixon Peabody will continue to monitor this litigation and updates in the cryptocurrency and blockchain technology space.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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