Dramatic price increases in cryptocurrencies are driving interest among investors. This interest has been fueled by celebrities, social media influencers and the media. Despite the growing popularity of cryptocurrencies, there is still a significant degree of uncertainty in the relevant legal landscape. This is primarily because the regulation of digital currencies is still evolving. The result: cryptocurrency litigation is on the rise and courts are determining to what extent existing laws apply. That also means added risks to buyers and sellers.
A cryptocurrency is a digital or virtual currency that is secured by cryptography, unique digital signatures and complex mathematical algorithms which protect the currency from counterfeiting. Many digital currencies use blockchain – a database that stores data in blocks that are then chained together. New transactions must be approved by a decentralized network of computers before being grouped in blocks in the database and chained to previous blocks to form a blockchain. This creates a permanent time-stamped public ledger that cannot be altered.
There are various types of cryptocurrencies, also known as “alt-coins” or “altcoins.” Among the best known are Bitcoin, Ethereum, Litecoin, Dogecoin, and Non-Fungible Tokens (NFTs).
The popularity of cryptocurrencies and the volatile market have attracted the attention of federal and state agencies in recent years. The Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Internal Revenue Service (IRS), Financial Crimes Enforcement Network (FinCEN), and New York State Department of Financial Services are among the agencies that regulate the use of cryptocurrencies. Governmental investigations and enforcement actions are typically based on allegations of fraud, misconduct, money laundering, and compliance with securities laws.
On the civil side, investors are also bringing lawsuits claiming fraud, market manipulation and violation of securities laws. Complaints alleging breach of contract, intellectual property infringement, trade secret misappropriation, and others have also been increasing.
Determining when a cryptocurrency is a security is important because securities must be registered and are subject to other rules. Noncompliance with these rules can result in criminal and civil liability. This issue is being litigated in multiple court cases. Some notable actions are discussed below.
The Ripple Labs lawsuit is an SEC enforcement action against Ripple Labs, Inc. (“Ripple”) alleging that its cryptocurrency XRP was sold as an unregistered security. The key question is whether the XRP offering is an investment contract (and thus a security) under the U.S. Supreme Court’s decision in SEC v. W.J. Howey Co. That case states that 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.” If XRP meets the test, it must be registered with the SEC and Ripple is liable for not registering.
Importantly, the SEC has determined that Bitcoin and Ethereum are not securities because they rely on a decentralized blockchain and thus they are not a “common enterprise with profits derived from the efforts of others.” However, the SEC alleges that Ripple is different because Ripple minted the entire supply of currency itself and utilizes a centralized infrastructure to process and validate transactions. Therefore, the SEC argues it meets the common enterprise test.
The case is being heard by the US District Court for the Southern District of New York.
This is a civil case brought in New York state court involving sales of the NBA Top Shot by Dapper Labs. NBA Top Shot sells digital “packs” of “Moments” – a type of NFT with video highlights of NBA games. Moments are created by the NBA, National Basketball Players Association, and Dapper Labs and then minted and sold via a blockchain. Some have sold for more than $200,000.
The complaint was filed on behalf of Virginia resident Jeeun Friel and others who were allegedly harmed by their purchases of Moments. Friel’s complaint alleges that the Top Shot Moments are a security under federal law and should have been registered with the SEC. The plaintiffs argue that Dapper Labs controls the new release of NFTs, prevents collectors from withdrawing funds for months, and restricts owners to selling through a secondary market where the company gets a 5% transaction fee. Plaintiffs also allege this is done in order to inflate the overall valuation of NBA Top Shot. As a result, the transaction allegedly meets the requirements of an investment contract under Howey.
However, plaintiffs may have difficulties in establishing liability as the user agreement all purchasers sign requires them to agree that they “are using NFTs primarily as objects of play and not for investment or speculative purposes.” In addition, the user agreement provides for arbitration of any disputes. If Dapper Labs fails to get the court case dismissed, the decision will turn on interpretation of Howey as with Ripple.
Two other recent cases are worth noting. In a lawsuit against Tezos Foundation, the plaintiff-investors alleged that its initial coin offering (ICO) was an unregistered securities sale. The case settled last year for $25 million, which means there is no court ruling on whether the ICO was a security.
Earlier this year, the IRS went to court to obtain account information from Payward Ventures, also known as “Kraken.” Under IRS rules, certain virtual currency transactions are taxable like any other property transaction and must be reported on the taxpayer’s tax returns. In this case, the IRS petitioned for a John Doe summons requesting information on all United States taxpayers who held accounts with Kraken with the equivalent value of $20,000 or more in cryptocurrency for any one year from 2016 through 2020. The purpose of the summons was to identify non-compliant taxpayers. However, the court ordered the IRS to provide more detail regarding why “each category of information sought is narrowly tailored to the IRS’s investigative needs.”
Cryptocurrencies have great potential to generate profits. However, it is important to understand the risks. The legal rules are still evolving, and many issues will be litigated. Consult an attorney before you invest substantial funds or if you feel a transaction you entered into was misrepresented.