April 24, 2018

Another fork in the road? Cryptocurrency class action lawsuit alleges securities violations and demands “rescue fork” as remedy

By Megha Shah, Marx P. Calderon and Caitlin Duncan

As the number of cryptocurrencies available over the internet continues to grow, their treatment in courts and with regulators remains to be seen. Cryptocurrency companies and users are waiting to see how the legal and regulatory industries react to them and the underlying Blockchain technology.

On April 6, 2018, plaintiff, Alex Brola (“Brola”) brought a class action lawsuit against NANO, a cryptocurrency company, and key members of NANO’s core team for violations of Section 12(a)(1) and Section 15(a) of the Securities Act, negligent misrepresentation, unjust enrichment and civil conspiracy in connection with the loss of $170 million worth of XRB from BitGrail, an Italian cryptocurrency exchange. See Alex Brola v. NANO et al., 1:18-cv-02049 (E.D.N.Y. filed April 6, 2018). As this case moves forward, we’ll start seeing more answers.

WHAT HAPPENED: Brola alleges that he opened an account at BritGrail for the primary purpose of investing in and exchanging a cryptocurrency called XRB, upon investment solicitations and specific instructions and representations of safety and security made by NANO representatives. Id. at *2. Brola further alleges that NANO publicly promoted BitGrail as a safe and reliable place for XRB holders to stake and exchange their XRB, and XRB holders relied on that endorsement by NANO in choosing BitGrail as their exchange. Id.

However, in early February 2018, BitGrail announced that it lost $170 million worth of XRB from its exchange due to unauthorized transactions. According to the class complaint, the loss accounts for approximately eighty percent (80%) of the XRB that BitGrail customers held in their accounts and fifteen percent (15%) of all XRB that exists. Id. at *9. Since this loss, BitGrail users attempted to move their XRB off the BitGrail exchange into private cryptocurrency wallets but BitGrail suspended all account activity. Id. at *10.

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Brola filed this suit under a theory that XRB is a security subject to U.S. securities laws. As such, Brola brings this private right of action under Section 12(a)(1) and Section 15(a) alleging that NANO misled investors into using the BitGrail exchange to invest in XRB.

According to the class complaint, NANO has failed to implement any solution to the loss of XRB for its holders. See id. at *10. Brola asserts that NANO can create a “rescue fork” where NANO would rewrite the XRB code and restore ownership to Brola and the purported class. Id. Brola further alleges that NANO has refused to implement such a remedy because NANO still owns and controls millions of XRB and does not want to sacrifice any financial advantage they currently have over XRB investors that lost their coins on BitGrail. Id. at *4.

IMPLICATIONS: This lawsuit requires that the court’s decisions be analyzed at every step for a number of reasons. The lawsuit brings up a host of questions that businesses and courts alike will face as Blockchain technology continues to develop and cryptocurrencies gain traction.

First, Brola asks the court to order NANO to create a “rescue fork” in a manner that results in rescission of all XRB held in accounts at BitGrail. A hard fork describes a major change to the code and Blockchain protocol, which can make previously valid blocks or transactions invalid. A hard fork usually results in two different coins with different ledgers and sets of code. Here, Brola asks the court to require a company to create a new coin, ledger and code to turn back the clock to before February 2018 when BitGrail announced the $170 million loss of XRB. This is a tall demand from a court, and Blockchain companies should pay attention to whether or not the court can require the company to essentially create a new product. Similarly, cryptocurrency users may be interested to see if they can recoup any of their losses by convincing a court to require a cryptocurrency company to execute a “rescue fork” to turn back time to compensate users who lost money.

Next, it will behoove cryptocurrency companies to pay attention to whether securities laws violations can be brought for a company’s alleged misrepresentation of an exchange as opposed to the cryptocurrency itself, either by private individuals or the SEC. Brola alleges that NANO’s core employees promoted BitGrail and caused it to be the “predominant and nearly exclusive home for XRB.” If this case proceeds, the court may have to address whether a cryptocurrency is a security subject to the Securities Act, as discussed further below. In a regulatory environment where the SEC, CFTC and other regulatory agencies have indicated a desire to exercise rulemaking authority, a ruling on whether or not cryptocurrencies are securities alone is likely to further open the regulatory can of worms that cryptocurrencies are striving to avoid or minimize as regulators contemplate implementing rules for investor protection.

Finally, as lawsuits increase, companies will face challenges in explaining the Blockchain technology behind cryptocurrencies to judges and juries alike. As with any type of litigation, expect to see issues arise in the discovery process to secure documents or information from a third party foreign exchange, like BitGrail; arguments about trade secrets; and the relationship between a cryptocurrency company and an exchange on which the currency is traded. Overall, this lawsuit will be interesting and important to track as one of the first of its kind, where the law and regulations relating to this new technology are still developing.

IS XRB A SECURITY? The SEC has not formally taken a position as to whether Bitcoin, the first and current largest cryptocurrency, is a security. However, the SEC to date has brought enforcement actions in this arena. Bitcoin does not neatly fall into any definition of a “security” under the Securities Act, but it does have attributes of instruments that do fall into that category. In SEC v. Howey Co, the court explained that an instrument is treated as a security if the “common scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”

Whether or not XRB or any new coin, will be viewed as a security, as always, depends on the facts. A good starting point is to look at the “investment” portion of the Howey definition. If Bitcoin is treated as any other currency, then purchasing “coins” is unlikely to trigger regulations. However, if the SEC finds that the primary purpose of purchasing these coins is the inherent speculation of cryptocurrency, there may be grounds for regulation that could lead to enforcement.

Press releases by the SEC indicate that quoted prices and other services often offered in connection with a security could tip the scales. It is prudent, then, that any player in this growing field remain mindful of what the SEC views as a security. As the industry grows, expect a higher degree of scrutiny on the unique characteristics of each coin and the associated offering. This lawsuit could provide some of the much needed clarity and guidance needed in this space.

Nixon Peabody will continue to monitor this litigation and updates in the cryptocurrency and Blockchain technology space. For questions related to cryptocurrencies, Blockchain or this litigation, please reach out to the authors or anyone in Nixon Peabody’s experienced Blockchain and Cryptocurrency group.

— Megha Shah at [email protected] or 312-977-9205 — Marx P. Calderon at [email protected] or 617-345-1205 — Caitlin Duncan at [email protected] or 617-345-6180