Eleven class actions were all filed on April 3, 2020, in the Southern District of New York against four crypto-asset exchanges and seven digital token issuers.
The plaintiffs allege that the defendants offered and sold billions of dollars of unregistered digital tokens and other financial instruments to investors in violation of federal and state securities laws.
The lawsuits name as defendants crypto-asset exchanges Binance, Bibox, BitMEX and KuCoin, as well as seven issuers of digital tokens: Block.one, Tron, Bancor, Civic, Kybercoin, Quantstamp, and Status, in addition to numerous company executives.
In a press release, Kyle Roche, a lead partner on the cases, explains that “[g]rowing enthusiasm for Bitcoin spilled over into the market for initial coin offerings (‘ICOs’), which investors flocked to in the hope of finding the next Bitcoin. The cases allege that exchanges and issuers failed to comply with federal and state securities laws intended to protect investors from unscrupulous behavior in the rush to capitalize on this enthusiasm.”
Mr. Roche further explains that “exchanges profited handsomely from listing these digital tokens on their platforms. In addition to receiving fees for each transaction performed on its exchange, Binance, for example, allegedly received large cash payments from issuers seeking to list tokens. These fees often exceeded $1 million per listing.”
The Securities Act allows investors to bring a private cause of action for offering or selling securities in violation of Section 5 of the Securities Act, so long as the claim is brought within one year after the violation upon which it is based and certain other criteria are met. Section 5 of the Securities Act provides that all offers and sales of securities must be either registered or exempt upon reliance on an available exemption from registration, otherwise they would be illegal.
The core allegations in the class actions stem from plaintiffs’ claims that the digital tokens that the defendants issued and sold are unregistered securities. According to the plaintiffs’ allegations, the investors purchased the tokens from 2017 through to the present, clearly more than one year from the filing date. How do the plaintiffs overcome this statute of limitations issue?
Presumably they will take the position that the statute of limitations did not start to run until April 3, 2019, the date of the issuance of the Framework for ‘Investment Contract’ Analysis of Digital Assets. According to the plaintiffs, “[p]rior to that time, a reasonable investor would not have believed that these Tokens were securities that should have been registered with the SEC.” They also allege that “before the SEC issued its Framework in April 2019, a reasonable investor would not have concluded that ERC-20 tokens were generally securities subject to the securities laws.”
This means that the April 3, 2020 filing date (of all 11 class actions) becomes very significant because it is one year to the day following the issuance of the Framework report. But is this date the dividing line after which a reasonable investor would know that digital tokens were unregistered securities? I doubt it.
The Framework report provides a detailed list of factors relevant to the Howey analysis (which provides criteria used to analyze what constitutes an investment contract — a type of security under federal securities laws) with respect to digital assets. However, it does not provide new substantive guidance. It merely summarizes existing rules. Further, the Framework report was not issued by the SEC, as asserted by the plaintiffs, but by the Strategic Hub for Innovation and Financial Technology of the Securities and Exchange Commission.
In his 2018 Statement regarding the Securities and Exchange Commission (“SEC” or the “Commission”) staff views, SEC Chairman Clayton explains that “it is the Commission’s longstanding position is that all staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties. Statements issued by SEC staff frequently include a disclaimer underscoring the important distinction between the Commission’s rules and regulations, on the one hand, and staff views on the other.” The first footnote to the Framework report makes clear that the report represents the views of the staff, and it does “not replace or supersede existing case law, legal requirements, or statements or guidance from the Commission or Staff.” It merely provides “additional guidance in the areas that the Commission or Staff has previously addressed.”
So, the viability of these cases will likely turn on the question of when an investor exercising reasonable diligence would have been put on notice that transactions in the digital assets at issue were potentially securities transactions. The seminal case of SEC v. Howey Co. which sets forth the test (criteria) for determining what constitutes an investment contract was issued in 1946. Its extensive progeny has been on the books for 74 years. Digital assets may be a relatively new concept, but investment contract analyses has been around for a while.
While the plaintiffs rely on the Framework report as the trigger for the statute of limitations, defendants and commentators will surely point to the SEC’s extensive guidance, speeches and enforcement actions, including the SEC’s July 2017 report of investigation, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, commonly referred to as the DAO report. That DAO report applied the Howey analysis to a digital asset called the DAO token, and found that the DAO token was a security under the Securities Act of 1933 and the Securities Exchange Act of 1934.
In the DAO report, the SEC cautioned that the Howey analysis is very facts and circumstances dependent and that transactions in digital assets may be subject to compliance with the requirements of the federal securities laws. The report emphasized that “[a]ll securities offered and sold in the United States must be registered with the Commission or must qualify for an exemption from the registration requirements” and that “any entity or person engaging in the activities of an exchange must register as a national securities exchange or operate pursuant to an exemption from such registration.”
Era Anagnosti, a partner with White and Case, and former SEC regulator with direct experience on how the SEC staff analyzes the application of the Securities Act to digital asset securities, says that the plaintiffs’ taking the position that a Section 5 violation occurred after the Framework came to light is creative, but it probably will not be successful. The Framework report did not change the longstanding application of the well-established federal securities law framework. It remains exactly the same.
Large class action lawsuits are expensive. Lawyers don’t bring them lightly. It would appear that the plaintiffs have a big hurdle to overcome. Did the statute of limitations begin to run on April 3, 2019 or sometime before that date? Will the Framework report somehow enable the plaintiffs’ claims to survive the dispositive motions that will likely be filed by the defendants?
We will have to wait and see.