The Legal Intelligencer: Emerging 'Securities' Litigation in Cryptocurrency — Kang Haggerty News

Courts will likely be grappling with questions regarding cryptocurrency for years to come—with the results from the suits against Binance and Coinbase potentially serving as guiding precedent in answering those questions.

In the July 6, 2023 Edition of The Legal Intelligencer, Edward T. Kang and Kandis L. Kovalsky co-authored, “Emerging ‘Securities’ Litigation in Cryptocurrency.“

Cryptocurrency has emerged as a revolutionary form of digital currency that has disrupted traditional financial systems and opened new possibilities for decentralized transactions. As the number of transactional options continues to grow, so does the risk for potential buyers, sellers, traders and investors. The world of cryptocurrency is complex and perpetually changing, creating a difficult landscape for financial agencies to oversee and regulate effectively.

The U.S. Securities and Exchange Commission (SEC) has repeatedly urged investors to take caution when considering an investment in cryptocurrency, pointing to the exceptionally volatile and speculative nature of the currencies (coins) and the lack of protections for investors in the cryptocurrency trading platforms. The SEC has explicitly stated that crypto trading platforms may not be complying with applicable federal securities law by allowing exchanges of coins that are not registered or exempt from registration with the SEC. Moreover, many crypto trading platforms have not registered as broker-dealers, investment advisers, alternative trading systems or exchanges subject to securities regulations. And many of these trading entities allow investors to “stake” their coins (the process of buying and holding coins with the goal of receiving interest). This practice may be subject to additional federal securities laws.

Two recent lawsuits filed by the SEC against crypto trading platforms, Binance and Coinbase, illustrate the ongoing struggle for tighter regulation of cryptocurrency trading. In filing these suits, the SEC alleges that the platforms have blatantly disregarded federal securities laws to enrich themselves with billions of dollars while placing investors’ assets at significant risk. To understand the nature of the pending lawsuits and the potential implications, it is necessary to have a brief understanding of the complex world of crypto trading.

Cryptocurrency is a digital, encrypted, and decentralized medium of exchange. There is no central authority that maintains the value of a cryptocurrency like there is for the U.S. dollar. While cryptocurrency can be used to buy goods and services, most people invest in cryptocurrency as they would in other assets such as stocks. The task of managing a cryptocurrency’s value is distributed among cryptocurrency’s users through the internet.

Cryptocurrency transactions are managed through cryptographic proofs that are verified and recorded on a blockchain—an open ledger that records all transactions in code. Transactions are recorded in blocks that are linked together on a chain of past crypto transactions. By using a blockchain, cryptocurrency users have their own copy of the transaction ledger to create a unified record. Every transaction is logged and updated in the blockchain simultaneously, keeping all records accurate and identical. Each transaction is validated through a consensus mechanism—the process in which a group of computers on a network determines the validity of all blockchain activity.

Two major consensus mechanisms are used to verify transactions: proof of work (PoW) and proof of stake (PoS). PoW verifies transactions by using an algorithm to provide a complex mathematical problem that computers race to solve. Each participating computer, referred to as a miner, solves this mathematical puzzle to verify a group of transactions (a block) and adds them to the blockchain ledger. The first computer to solve the complex puzzle is rewarded with a small amount of cryptocurrency. For example, a Bitcoin miner receives 6.25 coins for each block it validates. Due to the complexity of the puzzles, PoW verification can require immense power and electricity to complete validation. As of this column, Bitcoin continues to use the PoW verification system.

PoS verification was created to validate transactions in a more energy-efficient manner. In a PoS system, transactions are validated by investors who stake their coins to ensure the security of a blockchain. Each person who stakes crypto is eligible to verify transactions, with the odds of being chosen to verify transactions increasing with the number of coins fronted or staked. PoS validation removes the energy-consuming puzzle-solving, resulting in a more efficient system with faster verification times for transactions. The staked coins act as a guarantee that staking investors are acting in good faith and not violating the protocol rules. By staking some of their funds, investors make the blockchain more resistant to attacks and strengthen its ability to process transactions. Staking adds a level of security to the blockchain because it would require a bad actor to control at least 51% of all staked coins—a feat so difficult that it makes an attack extremely unlikely. PoS is the verification system that the blockchain-based software platform Ethereum uses to validate transactions. Binance and Coinbase both allow and promote staking by users of the platforms.

In its claims against Binance in the District of Columbia and Coinbase in the Southern District of New York, the SEC alleges that these platforms merge three functions typically separated in traditional securities markets: brokers, exchanges and clearing agencies. Accordingly, the SEC alleges that because Binance and Coinbase failed to register with the SEC as brokers, national securities exchanges, or clearing agents, they have evaded the disclosure regime that Congress has established for securities markets. The purposeful efforts to evade U.S. regulatory oversight allowed the defendants to transfer investors’ crypto assets as they pleased, at times commingling and diverting them in ways that properly registered brokers, exchanges and clearing agencies would not have been able to do. The SEC alleges that these platforms have earned billions of dollars in revenue by collecting transaction fees from investors who have been deprived of the disclosures and protections that registration entails, exposing them to significant risk. These lawsuits illustrate the idea that Congress has already enacted legislation regulating securities, and the SEC is simply asking the courts to apply existing securities law to cryptocurrency.

The SEC believes the vast majority of cryptocurrencies are securities based on the Howey test, the framework used to determine if an asset is a security articulated in SEC v. W.J. Howey, 328 U.S. 293 (1946). In deciding Howey, the court set forth the relevant test for determining whether a crypto asset is part of an investment contract subject to regulation under securities laws. Under the Howey test, an investment contract exists when there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” This test applies to any contract, scheme, or transaction regardless of whether it has any of the characteristics of typical securities. The test’s analysis is not only on the form and terms of the asset itself but also on the circumstances surrounding the asset and how it is offered, sold, and resold. Entities engaged in marketing, offering, selling, reselling, or distributing any asset must analyze the relevant transactions to determine if federal securities laws apply.

Cryptocurrency advocates argue that the novel technology falls outside the scope of the established Howey test and that it necessitates new rules to clarify the application of securities laws to crypto projects. Gurbir Grewal, director of the SEC’s Division of Enforcement, pushed back at this argument, stating that “the real issue is not that people don’t know what the rules are, they don’t like the results when you apply those rules to their projects.” SEC Chairman Gary Gensler recently stated in a New York Magazine interview that all cryptocurrencies except Bitcoin are considered securities because there is a group in the middle and the public is anticipating profits based on that group. Bitcoin has been classified as a commodity because investor profits are not dependent upon the efforts of developers or managers, thus failing to satisfy the “common enterprise” element of the Howey test. Whether Ethereum, second only to Bitcoin in market capitalization, should be classified as a security remains uncertain. Before his appointment as SEC chairman, Gensler publicly stated that he did not consider Ethereum a security but has recently avoided directly addressing its status. During a hearing before the House Financial Services Committee in April of this year, Gensler repeatedly responded, “it depends on the facts and the law” when questioned about Ethereum’s classification.

In its suit against Coinbase, the SEC named 13 coins it deemed fit into the securities classification. These recent additions bring the growing list of crypto coins deemed securities to 55, totaling over $100 billion of the market. These pending suits mirror claims brought by the SEC against similar trading platforms earlier this year. Marc Fagel, former head of the SEC’s San Francisco regional office, has indicated that the Coinbase suit takes a broad look at the industry by asking if a coin in the secondary marketplace is a security covered by securities laws. “It’s a defining moment for the question ‘Is there something about crypto that is different from all of the securities, or is it going to be treated like any other?’” he questioned. The answer to these questions will likely impact everyone involved in the crypto market. The growing number of lawsuits against crypto trading platforms and Gensler’s statement regarding the status of all cryptocurrencies as securities indicate that these lawsuits are just the beginning of what will likely be future suits brought against crypto trading platforms for securities law violations. It is indicative of a future where crypto trading occurs under more stringent regulations and crypto trading platforms are required to follow all securities regulations and requirements.

A large part of cryptocurrency’s appeal is that it is mainly independent of intermediary entities and free from regulation by institutions like the SEC and the U.S. Department of the Treasury. The lack of oversight has allowed cryptocurrency to operate on a near-instantaneous basis among its many users without fear of outside intrusion. The recent actions taken by the SEC may dissuade potential investors, traders, stakers, and trading platforms from getting involved with cryptocurrency. The unclear landscape of the future of crypto assets looms over those who wish to get involved, and the pending litigation over the status of coins as securities likely mars what once made cryptocurrency alluring. With the pending litigation occurring in different districts, the possibility of a circuit split may add to this confusion and unease over the future of crypto. Without guidance from the court, such a circuit split could result in trading platforms redirecting their businesses to practice in areas where coins are not deemed securities. In the event of a circuit split, the future of cryptocurrency may become even more unclear than it currently stands.

Regardless of the outcome of the pending cases, the U.S. government has made a clear effort to implement tighter restrictions on crypto trading and hold exchange platforms responsible for protecting their users. Courts will likely be grappling with questions regarding cryptocurrency for years to come—with the results from the suits against Binance and Coinbase potentially serving as guiding precedent in answering those questions. Practitioners—both securities law lawyers and other litigators—should follow these developments closely as they are likely to be called upon to represent investors in cryptocurrencies in the near future.

Edward T. Kang is the managing member of Kang Haggerty. He devotes the majority of his practice to business litigation and other litigation involving business entities. Contact him at ekang@kanghaggerty.com.

Kandis L. Kovalsky, a member at the firm, focuses her practice on representing both corporate and individual clients in a broad range of complex commercial litigation matters in Pennsylvania and New Jersey state, federal and bankruptcy courts. Contact her at kkovalsky@kanghaggerty.com.

Reprinted with permission from the July 6, 2023 edition of “The Legal Intelligencer” © 2022 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.