Initial Coin Offerings Set Stage for Litigation Wave

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By Michaela Ross

Initial coin offerings are attracting billions of dollars in financing, a growing pool of unsophisticated investors, and increased regulatory scrutiny.

That’s a recipe for a wave of private litigation, financial services and commercial litigation attorneys and policy researchers analysts told Bloomberg BNA.

The nascent technology is drawing legal scrutiny as it becomes an increasingly popular way to raise money. Instead of selling shares of stock, as in initial public offerings, more and more companies are selling digital coins or tokens in initial coin offerings that can represent ownership shares, currencies, or be redeemed for a good or service.

Private lawsuits filed against token issuers or the exchanges they trade on could curtail the use of initial coin offerings, or ICOs, as well as drive new business to law firms specializing in the industry—both from investors seeking redress and future token issuers looking to reduce legal risks through due diligence, attorneys and policy groups said.

“A successful civil claim against a token issuer for fraud or securities violations may trigger a flurry of other similar suits, but each case will vary based on the details of the sale,” Andrew Hinkes, a dispute resolution attorney at Berger Singerman LLP, told Bloomberg BNA.

ICOs have attracted $1.6 billion in venture capital in 2017 so far, according to August data on Ethereum-based ICOs from Chainalysis, a New York-based research and anti-money laundering software company. The number of individual investors buying and trading these coins is booming. Bittrex LLC, a popular exchange that trades about 200 types of tokens, saw its user base grow from 1 million to 1.2 million in a span of two weeks in August, according to its co-founder and CEO, Bill Shihara.

The pace of initial coin offerings accelerated in the summer of 2017, when ICOs by Bprotocol Foundation and the Tezos Foundation set new records by surging past the $150 million and $230 million marks, respectively. Bprotocol Foundation is developing a protocol called Bancor that it says aims to allow buyers to create customized tokens that can be traded against a variety of other tokens. Tezos Foundation is developing an independent blockchain platform.

The soaring valuations of new tokens and the major blockchain technologies underlying them, such as Bitcoin and Ethereum, have drawn new investors that may not understand how the tokens work, could lose money, and may not know how to recognize whether the tokens should be valued as a security, cryptocurrency, or utility.

Those factors are attracting bad actors and artificially driving up valuations of some assets that, once deflated, are likely to spur private litigation against companies and individuals issuing and exchanging these tokens, attorneys and research groups said. Three lawsuits involving ICOs have been filed, Bloomberg Law data show, but none involved investors suing initial coin offerings issuers or exchanges on which they trade ( Audet et al v. Garza et al , D. Conn., No. 3:16-cv-00940, complaint filed 6/15/16 , United States v. Coinbase, Inc. , N.D. Cal., No. 3:17-cv-01431, complaint filed 3/16/17 , R3 Holdco LLC v. Ripple Labs, Inc. , Del. Ch., No. 2017-0652, complaint filed 9/8/17 ).

Increased regulatory scrutiny, including by the U.S. Securities and Exchange Commission, will improve investor understanding of how these digital assets should be classified and reveal fraudulent schemes, opening the door to litigation against companies that are misrepresenting themselves or acting illegally, the groups said.

“Once the SEC starts getting involved, then the ball tends to start moving faster,” Knight told Bloomberg BNA.

The Fraud Factor

Tokens issued by ICOs can offer consumers legitimate, innovative investments or services, attorneys and policy groups said.

Still, private investors may come after companies that commit outright fraud or breach of contract by failing to deliver tokens or misrepresenting their technology in several different ways, Stephen Palley, corporate and commercial litigation attorney at Anderson Kill P.C., told Bloomberg BNA. China’s central bank banned all ICOs in the country Sept. 4, following widespread concerns about whether some coin developers were operating legally, while the SEC and Britain’s Financial Conduct Authority have issued consumer warnings about fraudulent and risky offerings.

New investors who are attracted to rising ICO values but don’t have the technical expertise to evaluate a scam may also drive up market values, leading to more lawsuits from those who have lost money to criminal operators.

“There are some really good people out there who are making useful things with blockchain,” Palley told Bloomberg BNA. “There’s also a lot of garbage.”

Virtual Identity Crisis

ICO investors may also file suit against companies and exchanges that—even unknowingly—incorrectly classify tokens. The evolving technologies behind the coins can make it difficult to determine if a token is a security, utility, or digital currency, attorneys told Bloomberg BNA.

That means that companies and investors issuing and exchanging tokens might not be in compliance with either securities or money services business regulations, such as SEC registration and investor disclosure requirements; state money transmitter licensing laws; and anti-money laundering rules.

“Even if there isn’t outright fraud, in the securities context, if the token security was issued not in accordance of the law, the investor has the right of rescission, which is the right to unwind this transaction with the company,” Brian Knight, a senior research fellow at the Mercatus Center at George Mason University, told Bloomberg BNA.

The coders or entrepreneurs behind ICOs often aren’t familiar with the public disclosures required of companies soliciting investors.

“Compared to a traditional security, there are frequently little to no public disclosures made to potential investors,” Hinkes told Bloomberg BNA. “These disclosures are there to protect consumers, and these ICOs typically don’t come within a mile of disclosure that would be required in a securities offer,” Hinkes said.

The increased regulatory scrutiny by the SEC, the U.S. Financial Crimes Enforcement Network (FinCEN) and other agencies since July has already lead to more new ICOs taking legal due diligence steps, Hinkes said. But the rising attention from regulatory bodies will also likely spur individual investors to take a closer look at what they’ve already bought and potentially file lawsuits, Knight added.

Still, fraud litigation will impact all types of tokens, not just securities, Nathalie Salami, a blockchain attorney with Fintech Portfolio, which helps companies offer compliant ICOs, told Bloomberg BNA. Issuers of utility coins selling future access to a product or service, such as a set amount of cloud storage, could fail to deliver their product or misrepresent it, she said.

“Consumer laws exist outside of the SEC,” she said.

Litigation Roadblocks

Unhappy investors will face hurdles to suing a coin issuer or the exchanges it trades on.

Private litigation could be thwarted because it can be hard to identify the party to sue, Hinkes said. Many coin platforms are established as open-sourced technologies under a foundation or non-profit framework, and not as companies, attorneys told Bloomberg BNA. The global nature of the technology and its developers also means it could be tough to establish that a particular court has jurisdiction to hear a case, they said.

Coin offerings with terms of service that included arbitration provisions may also be able to skirt litigation, Hinkes said.

Still, attorneys and policy groups said they’re expecting private lawsuits to be filed when valuations of coins—either legitimate or fraudulent—eventually tumble and investors begin losing money and scrutinizing what they purchased.

“The larger a market becomes, the more people are involved, the more money involved, the more likely you have litigation,” Palley said, adding “People lose money, then sue.”

To contact the reporter on this story: Michaela Ross in Washington at mross@bna.com

To contact the editor responsible for this story: Keith Perine at kperine@bna.com

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