By Matthew Bultman
A federal judge’s recent refusal to approve blockchain-technology developer Block.one’s $27.5 million settlement with cryptocurrency investors is spotlighting plaintiffs’ challenges in class actions to recoup their money from foreign crypto companies.
Federal securities law’s reach is limited to “domestic transactions” in legal disputes involving securities not traded on a US exchange. Determining what’s a domestic or foreign transaction is more difficult in cryptocurrency, which is developed, bought and sold through a set of decentralized computers worldwide.
And as Williams et al v. Block.one shows, that distinction is important when considering proper class representation in crypto investors’ disputes. Crypto Assets Opportunity Fund—as a fund that conducted both foreign and domestic transactions of tokens sold by Block.one—hadn’t shown it could adequately represent other investors whose transactions mostly took place in the US, US District Judge Lewis Kaplan of the Southern District of New York ruled Aug. 15. Kaplan declined to approve the proposed settlement and appoint Crypto Assets as class representative.
The issues in Kaplan’s ruling will undoubtedly emerge in other similar lawsuits as the fallout from cryptocurrentcy volatility expands. Kaplan’s ruling is one of the few early cases that directly advances the argument—and could serve as a guidance case—on what constitutes a domestic transaction in crypto currency trading.
The case illustrates “the difficulty of trying to determine whether you have a US transaction,” Proskauer Rose LLP attorney Jonathan Richman said. The ruling also underscores the challenges of dealing with those questions on a classwide basis.
“You’re going to have to deal with the differences among the class members in terms of whether they do or don’t have transactions that are subject to the US securities laws,” Richman said.
Investor class actions related to cryptocurrency are on track to hit a record high in 2022, a recent report from Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse shows. Ten class actions were filed in the first half of 2022, compared to 11 during all of last year.
“Not only do we not have guidance from the US Supreme Court on what domestic transactions in general means, we don’t have guidance in the context of crypto assets, which in and of themselves are different from every other kind of security,” University of Arkansas law professor Carol Rose Goforth said.
Investors sued Cayman Island-based Block.one in 2020, alleging the firm defrauded them “through a year-long illegal initial coin offering.”
Block.one agreed the previous year to pay $24 million to settle Securities and Exchange Commission allegations that it sold unregistered securities.
Block.one, which has maintained the investors’ suit is “without merit” and “filled with numerous inaccuracies,” reached a separate $27.5 million settlement with them, resulting in a recent hearing before the New York court.
In his ruling, Kaplan referred to a 2010 Supreme Court ruling in Morrison v. National Australia Bank, which limited the reach of US securities law to securities listed on domestic exchanges and to “domestic transactions” in other securities.
“Which blockchain transactions are domestic and which are not remains a relatively novel question,” Kaplan wrote.
Various circuit courts, including the U.S. Court of Appeals for the Second Circuit, agree a transaction is domestic if “irrevocable liability” shifted from the seller to the investor in the US. Courts have grappled, however, with what “irrevocable liability” means in the context of a blockchain transaction.
“The more complex an international transaction is, it’s often very hard to say what the place of it is,” Norton Rose Fulbright US LLP attorney Robert Schwinger said.
With blockchain, “when the thing is passing through many, many nodes of computers all around the world, it’s vastly more complicated than your traditional securities scenario,” Schwinger said. A node refers to a computer linked to the cryptocurrency network.
In a case involving the Tezos blockchain project, a California district court judge said a transaction became irrevocable “after it was validated by a network of global ‘nodes’ clustered more densely in the United States than in any other country.”
A New York judge, in a case brought by investors who bought the HelbizCoin cryptocurrency, focused on the purchaser’s location at the time of transaction. In Utah, a district court found transactions in securities sold over the internet occur in both the seller’s and buyer’s locations.
“There are at least differences in nuance in the existing case law about trying to figure out where irrevocable liability is incurred between the buyer and the seller in a blockchain transaction,” Richman said. “This is certainly evolving.”
Kaplan appeared to question some of the existing approaches in the case against Block.one. The judge ultimately suggested a proper test to determine if a cryptocurrency transaction is domestic is to find out which computer “node” first verified the transaction.
Such a test “appears to be administrable” and follows Second Circuit precedent, he said.
An advantage of such a test is that it’s simple, said Samuel Dibble, an attorney at Baker Botts LLP, although it’s not clear it can fit all blockchain transactions. The simplicity of the test has the potential to create problems.
“People will try to evade the jurisdiction of the United States by directing traffic outside for the first node verification,” Indiana University law professor Sarah Hughes said.
At the heart of Kaplan’s decision was concerns about whether the lead plaintiff adequately represents the proposed class of investors.
He worried Crypto Assets may have an incentive to accept a lower settlement offer than would’ve been demanded by investors who engaged primarily in US transactions.
He noted the deal was 75% less than the total alleged loss “largely because of the presence of foreign purchases.”
The judge said he “implies no misconduct or criticism of the Lead Plaintiff or its experienced and well regarded Lead Counsel.” Rather, this was “a structural problem having roots in the unusual market that the case concerns.”
There could be solutions to this type of problem, attorneys say. On Monday, an individual who said nearly all of his token purchases were domestic asked to be substituted as lead plaintiff in the litigation.
Still, Kaplan’s ruling is “definitely a warning that [these cases] are complicated,” Richman said.
To contact the reporter on this story: Matthew Bultman in New York at mbultman@correspondent.bloomberglaw.com
To contact the editors responsible for this story: Melissa B. Robinson at mrobinson@bloomberglaw.com, Roger Yu at ryu@bloomberglaw.com
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