Pending Litigation Could Impact Crypto in 2023 and Beyond
Top crypto legal cases broken down below
Given the headlines from 2022 (Celsius, 3AC, Terra/Luna, FTX, etc.), this year could be a turning point for crypto regulation and legislation. While the U.S. government has yet to put their heads together and come to an agreement on top down legislation, there are some core legal issues that courts are likely to rule on this year or over the next few years. Let’s dive right in:
Bankruptcy
In re FTX, Debtors - Who owns your deposit in a bankruptcy?
Once hailed as the JP Morgan of our times, Sam Bankman-Fried (SBF), among others, allegedly perpetrated an $8 billion Ponzi scheme, which involved taking and diverting customer funds. This violated FTX’s terms of service, which stated that customers retained control and title to their digital assets and that title would not be transferred to FTX.
Why this is important: The important question is will FTX customers be deemed unsecured creditors, or will they be treated as custodial deposits? This means a world of difference in how they are treated in a bankruptcy. If treated as an unsecured claim, the customers would have to get in line with the other unsecured creditors instead of having priority and getting paid back first.
In the Celsius bankruptcy case, the judge ruled that the Earn Accounts were part of the bankruptcy estate, and those holders would have to wait in line with the other unsecured creditors. Why? The judge found Celsius’s terms of use to be a valid contract, and per its language, the terms clearly transferred title and ownership from the account holder to Celsius and thereby, was property of the Celsius bankruptcy estate.
However, the Celsius judge also ruled that certain custody customers could get their money back first – those whose digital assets weren’t commingled, weren’t bearing interest, and were small amounts to not be worth the expense of the courts to claw it back (it was only $50M in aggregate). It’ll be interesting to see if the FTX judge will also lean heavily on FTX’s terms of service to decide where in line customer accounts will wait.
One other topic of concern for many is whether any pre-bankruptcy withdrawals will be clawed back. When a company files for bankruptcy, an automatic stay goes into place, which basically prevents anyone from extracting payment from a bankrupt party (the debtor). The bankrupt company or bankruptcy trustee can demand the return of payments made within the 90 day period prior to filing for bankruptcy – called a preference demand. The rationale is that it would be unfair to “prefer” one creditor over another and would be more equitable to bring the money back into the bankruptcy estate to be evenly distributed to everyone. Clawing back funds is an expensive and laborious undertaking for a debtor, so oftentimes parties will reach a deal to return part of the money rather than going through the full claw back process. Complaint
Criminal
US v. Samuel Bankman-Fried – Will there be some IRL criminal implications for crypto’s poster child?
This is THE fraud of the industry (so far, but fingers crossed). What is interesting about the criminal case brought against SBF is that he has been positioning himself publicly to say he had no intent to do wrong, that he made a mistake, and that it’s no crime to be a bad businessman. All signs (and plea deals from Caroline Ellison and Gary Wang) indicate that he was well aware of what was going on between FTX and Alameda and perpetuated an ongoing fraud.
Why this is important: If SBF is able to overcome such criminal charges, it sends a bad message to the industry and society as a whole that crypto is dangerous because consequences can be evaded. Even someone from MIT couldn’t control it! There needs to be some personal accountability for a bad actor; if not, then we fear there will be a push for regulation that would overreach and stunt the industry. Complaint
US v. Chastain - Is it still insider trading if it’s on the blockchain?
This is the first insider trading case brought by the Department of Justice (DOJ) involving NFTs. Chastain was a product manager at the NFT marketplace OpenSea and was charged with wire fraud and money laundering for allegedly using the top secret info he had on NFTs that were to be featured on the OpenSea website. Note, the DOJ doesn’t need securities to be involved to bring a case for fraud and money laundering. In response to the charges, Chastain asserted that the information he had was not confidential business information, and since he conducted his trades on the Ethereum blockchain in public view, his actions were not designed to be concealed and therefore were not money laundering. The court dismissed Chastain’s motion to dismiss arguing that his points were better left for a jury or judge to decide.
Why this is important: The Southern District of New York (SDNY) has prioritized crypto-related criminal cases as the SDNY has brought criminal charges in the SBF/FTX related cases and Wahi (see below). If a court ultimately holds that moving digital assets on a public blockchain (i.e. not done in secret) could be used as a means to conduct money laundering or fraudulent activity, then such a decision could encourage further actions to be brought regarding such activity. Moreover, it could invite DeFi-level scrutiny to NFTs. Indictment
NFTs
Jeeun Friel v. Dapper Labs, et. al. - Can NFTs be securities?
What we hope won’t be a slam dunk case, Jeeun Friel has sued Dapper Labs for selling unregistered securities (its “NBA Top Shot Moments”) in violation of securities laws claiming the NFTs were “investment contracts” under the Howey Test. Friel had purchased Top Shots Moments and filed the class action lawsuit to represent other Top Shot Moments purchasers. Dapper Labs pushed back arguing that NFT purchasers do not share horizontal or vertical commonality (no common enterprise) and that the purchasers do not have a reasonable expectation of profits arguing NFTs are “objects of play and not for investment or speculative purposes” akin to baseball cards. In August 2022, the defendants filed motions to dismiss the case.
Why is this important: If the case is allowed to proceed and ultimately ruled in favor of the plaintiff, it could establish legal precedent that an NFT creator issues a security when it sells its NFTs. Doubtful that any apes, birds, or punks want to knock on the SEC’s door. Complaint
Yuga Labs, Inc. v. Ryder Ripps, et. al. – Do NFTs come with normie IP rights?
Bored Ape Yacht Club (BAYC) accused a group of defendants of scamming consumers into purchasing fake Bored Ape NFTs by copying the original images and calling them “RR/BAYC” NFTs. BAYC brought a case for trademark infringement, false designation of origin, false advertising, cybersquatting, conversion, unjust enrichment, etc. Defendants fought back saying the case was a violation of their free speech under Rogers v. Grimaldi, which held that the use of a trademark in an expressive work was protected under the First Amendment for artistic relevance. The judge in December 2022 disagreed and ruled that the case can move forward to be tried as the judge reasoned that the defendant’s NFTs were pointing to the same digital assets.
Why is this important: If BAYC wins the case, it will solidify the ability of NFT creators and owners to protect and monetize their intellectual property rights. Complaint
Regulatory
SEC v. Wahi - Can the SEC unilaterally determine that a token is a security?
Get your popcorn - this is the first insider trading case brought involving cryptocurrencies (the DOJ brought a criminal case, and the SEC brought a civil case). Ishan Wahi was a product manager at Coinbase and is accused of using confidential information about which cryptocurrencies were going to be listed on the Coinbase exchange. Wahi took that information and shared it with his brother and friend who used that information to make a series of trades resulting in $1.5 million in profits. To conceal their tracks, the brother and friend used accounts in the names of other people and transferred funds through multiple wallets. The brother pleaded guilty to the DOJ’s complaint in September 2022, and Wahi has subsequently pleaded guilty to his DOJ charges in February 2023. He has since filed a motion to dismiss the SEC’s civil charges, but it remains to be seen whether the dismissal will be granted.
Why is this important: What was unusual about the complaint brought by the SEC was that in addition to addressing the matter of insider trading, it also drew the conclusion that nine crypto assets were “crypto asset securities.” If the SEC were to win, it could be encouraged to continue regulation by enforcement. You’d likely see further actions against exchanges that don’t delist the digital asset as well as a slew of class action lawsuits against exchanges and other companies. It would create a can of worms – new NFT collection idea? Complaint
CFTC v. Ooki DAO - Can DAO members incur personal liability?
How do you sue an unincorporated DAO? Well, that’s being answered by the Commodity Futures Trading Commission (CFTC) who has sued the Ooki DAO for allegedly offering leveraged and margin trading products without registering as a futures commission merchant with the CFTC.
Why is this important: The Ooki DAO case concerns the fundamental issues of (i) whether the CFTC satisfied notice requirements and properly served the defendant, Ooki DAO, by posting summons documents in Ooki DAO’s online discussion forum and its help chat box, and (ii) whether a DAO qualifies as an unincorporated association thus allowing courts to impose personal liability on individual token holders for the actions of a DAO. The CA U.S. District court has already ruled on the first matter affirming that the CFTC did in fact satisfy the notice requirements, and in its ruling, also noted that Ooki DAO qualified as an unincorporated association in CA and could be sued as a collective. The court cautioned however that it was not ruling on the merits of the CFTC’s charges and only that the CFTC sufficiently alleged, for the purposes of their service motion, that Ooki DAO is an unincorporated association. While there are currently dismissal motions pending, this is a case worth paying attention to as a final ruling could have broad implications on unincorporated DAOs. Complaint
SEC v. Ripple Labs – Will an ICO be ruled a securities offering?
This is the OG case concerning the issuance of unregistered securities in which the SEC alleges that Ripple failed to register its token XRP in its $1.3 billion offering (i.e. arguing that XRP is a security). Back in September 2022, both Ripple and the SEC filed for summary judgment to require the judge to rule on whether or not XRP was a security.
Why is this important: If the judge were to rule that XRP is a security, the SEC would likely win its case. Given the lack of clarity in the US on regulating crypto, agencies will continue to step in and carve out some territory for themselves. In this case, if XRP is deemed a security, it could mean that other digital assets will be considered a security and cement the SEC’s talons in regulating this space. Complaint
Why is any of this important?? Remember that law is created by both the legislative branch (code) and the judicial branch (case law). Until Congress comes together on comprehensive legislation, the crypto legal landscape will continue to be shaped by regulatory and legal actions (like the ones mentioned above). How the courts rule here could have a more immediate impact on the endogenous growth of crypto. Keep an eye on what’s happening in DC, and you can always phone your congressman!
Disclaimer: This post is for general information purposes only. It does not constitute legal advice. This post reflects the current opinions of the authors. The opinions reflected herein are subject to change without being updated.