Crypto Caselaw Minute, Week of 11.25.18: Security blank-ed? Just because it isn't a security doesn't mean it isn't fraud

The Block is delighted to bring you expert cryptocurrency legal analysis courtesy of Stephen Palley (@stephendpalley) and Nelson M. Rosario (@NelsonMRosario). They summarize three cryptocurrency-related cases on a weekly basis and have given The Block permission to republish their commentary and analysis in full.

Even the SEC has bad days, Antminers meet the UCC, and bad things that happen when you lie about a securities offering. All of this and more in today’s Crypto Caselaw Minute! (As always, Rosario summaries are “NMR” and Palley summaries are “SDP”).

Disclaimer: These summaries are provided for educational purposes only by Nelson Rosario [twitter: @nelsonmrosario] and Stephen Palley [twitter: @stephendpalley]. This is not legal advice. These are our opinions only, aren’t authorized by any past, present or future client or employer. Also we might change our minds. We contain multitudes. 

SEC v. Blockvest, 2018 U.S. Dist. LEXIS 200773 (S.D. Cal., 8CV2287-GPB(BLM), November 27, 2018) [SDP]

We’ve said before that allegations aren’t facts and that the Plaintiff  -- whether that’s the government or a private party --  has the burden of proof. This case is an example of how that works in the SEC enforcement action context where the SEC alleged the defendant had sold unregistered securities in the form of ICO tokens. (Also, n.b. — if it’s not a security … you can’t be liable for securities fraud).

A little background to start.

The SEC initially sued Blockvest and its principal “Reginald Buddy Ringgold, III a/k/a Rasool Abdul Rahim El” alleging violations of the anti-fraud provisions of the Securities Act and the Exchange Act and violation of the registration requirements of the Securities Act.

The Complaint alleged that defendants (1) sold “BLV tokens” to raise capital for their business and that the BLV tokens were unregistered securities, (2) falsely claimed to be “registered and approved” by the SEC, CFTC, and NFA and had “partnered with” and been audited by Deloitte. As icing on the cake, the SEC alleges that:

"In order to create legitimacy and an impression that their investment is safe, Defendants also created a fictitious regulatory agency, the Blockchain Exchange Commission (“BEC”), creating its own fake government seal, logo, and mission statement that are nearly identical to the SEC’s seal, logo and mission statement. Moreover, BEC’s “office” is the same address as the SEC’s headquarters."

The Court granted an ex parte TRO freezing assets, prohibiting document destruction, granting expedited discovery, and accounting. Those things happened and a hearing was held earlier in November where the Court considered whether or not to turn the TRO into a preliminary injunction. 

The Court denied the request for a preliminary injunction. To understand what that means you need to know a little something about TROs and injunctions.

A TRO or “temporary restraining order” is a type of a preliminary injunctive relief. It allows a court when certain things are shown (irreparable harm, likelihood of success on the merits are a couple) to basically freeze things where they are and preserve the status quo. It’s an equitable not a legal remedy if we’re going to be lawyerish here. It’s also TEMPORARY. These things are issued and dissolved all the time. (n.b.: the SEC has a lower burden of proof for issuance of a TRO than a private litigant).

After a TRO you can request a preliminary or a permanent injunction. I am going to oversimplify a lot here so don’t send me an aggravated email Professor Drobak, but these things serve two general purposes (1) restraining/preventing ongoing harm and (2) remedying past harm. Sometimes a hearing on the two things is merged (that didn’t happen here). If the hearing isn’t merged, when you lose a preliminary injunction you still get a shot a permanent injunction. It may just be that you didn’t have enough evidence yet.

As this Court puts it: “The grant of a preliminary injunction is the exercise of a very far reaching power never to be indulged in except in a case clearly warranting it ... [O]n application for preliminary injunction the court is not bound to decide doubtful and difficult questions of law or disputed questions of fact.”

In responding to the SEC’s complaint, the Defendants only challenged the SEC’s claim that the BLV tokens were securities under federal securities laws. If they’re not securities … the fact that this may have been dodgy for a host of other reasons may remain (and other agencies may be interested) but the SEC’s claims would fail. (n.b.: As a tactical matter, it was probably wise to focus on this one narrow issue: “not a security, so you don’t have a case, whatever you think of our logo or other claims”).

Defendants responded that as factual matter they never sold BLV tokens to the public but only used them for testing. “The BLV tokens were only designed for testing the platform and no tokens were released to the 32 testing participants … Moreover, Defendants argue there is no common enterprise and the tokens do not represent an interest in or obligation of a corporation or other business. Therefore, Defendants argue the BLV token is not a 'security.'”

The Court applied the Howey test: was there “(1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others.” You have to have all three. First, the court asked whether there was an investment of money? The SEC pointed to a “buy now” button on the website but Ringgold said during his deposition that while there was a “buy now” button on the Blockvest website it was “only for testors and management” and wasn’t really live yet because coins couldn’t be purchase yet.

The Court said that “because there are disputed issues of fact” it can’t make a decision about this yet. Second, the Court asked did the “test investors” have an expectation of profits? The Court also said that there wasn’t any evidence presented to show this. (By profits, the Court was referring to “either capital appreciation resulting from the development of the initial investment … or a participation in earnings resulting from the use of investors’ funds.”)

The Court didn’t look at the common enterprise argument and really didn’t need to because once you knock out one prong there’s no security anyway.

Another factor that seemed to persuade the Court that an injunction wasn’t necessary is that the Defendants promised not to hold an ICO and will provide the SEC with 30 days’ notice if they decide to. So there’s no need to enjoin this activity (which if you think about means maybe the SEC already kinda won, by securing voluntary compliance).

I was asked on Twitter if this means that it’s open season for ICOs to go back to token sales in the U.S. without worrying about the SEC. The answer to that is decidedly no. This is a federal judge doing what federal judges do  --  applying the law to the facts and requiring a plaintiff to prove their case. Also, while I am not saying this project is or is not a fraud you can definitely commit fraud without committing securities fraud.

This case is not over yet. If and when there’s a permanent injunction hearing and order, or any other order that’s relevant in this case, we’ll report back to you on it.

SEC v. REcoin Group Foundation, LLC, et al., (E.D. N.Y., 17-CV-5725 (RJD), November 19, 2018) [NMR]

The end of an era is upon us. Way back on September 29, 2017, the SEC took their first steps to stop fraud in the ICO space by moving to halt the public sales of two ICOs: the REcoin ICO and the Diamond IMO. The SEC would bring a civil action against the man behind both of these ill-fated endeavors, Maksim Zaslavskiy, and on November 21, 2017, the Department of Justice brought criminal charges. On November 18, 2018, Zaslavskiy and the SEC reached a partial settlement (subject to the court’s approval) while Zaslavskiy awaits sentencing in his criminal case.

[related id=1]Let’s take a trip down memory lane looking back at the first ICOs that came under fire.

In some respects, the particular details of these two ICOs are not terribly important. Suffice to say, promises and statements were made that were not true. If you are launching an ICO don’t lie about whether you are actually building the blockchain network, and don’t lie about your tokens, and don’t … Listen, just don’t lie.

For those that do not recall, Zaslavskiy initially “launched” the REcoin ICO in July 2017. The ICO offered a token that would be backed by real estate held by the REcoin Group Foundation that was located in developed economies around the world. Individuals could buy into the ICO using credit cards and cryptocurrency, and in exchange they would receive a certificate proving their ownership of the tokens. They received certificates of ownership for their tokens. That should have been a giant red flag to participants, and perhaps it was. As you can imagine Zaslavskiy made many boisterous claims about the investment potential of REcoins, and about how well the ICO was doing financially, and he made all of these statements on the website for the sale. These statements were all false and misleading.

On October 6, 2017, Zaslavskiy announced his team was “switching strategies from backing their offering with real estate to backing it with diamonds, and that “all REcoin holdings will be seamlessly converted into Diamond Reserve Coin.” The Diamond IMO was an Initial Membership Offering that was functionally the same as an ICO. The IMO started in September 2017 and was proceeding along, and promoted by Zaslavskiy, in much the same fashion as the REcoin ICO. Similarly, all the statements related to the IMO were false or misleading.

So, why the sudden partial settlement? Well, the writing was on the wall. Initially, the SEC brought a civil action against Zaslavskiy. Not long after that the Department of Justice brought a criminal action against Zaslavskiy alleging conspiracy to commit securities fraud as well as securities fraud. Three criminal counts in total for the two ICOs. That indictment was upheld as lawful in September of this year, and on November 2, the Department of Justice brought a superseding indictment and tacked on a charge for conspiracy to commit wire fraud. The theory of their case was that Zaslavskiy and others devised a scheme to defraud investors in the ICOs:

“To obtain money and property from them by means of materially false and fraudulent pretenses, representations and promises, and for the purpose of executing such scheme and artifice, to transmit and cause to be transmitted by means of wire communication in interstate and foreign commerce writings, signs, signals, pictures and sounds, contrary to Title 18, United States Code, Section 1343.” (emphasis added)

With the additional wire fraud charge, and after losing the motion to dismiss the securities fraud charges against him, Zaslavskiy probably realized the jig was up and there was not much point to continue the fight. As stated in the partial settlement, “[t]he proposed judgments would resolve Defendants’ liability in this action and all non-monetary relief the Commission seeks against Defendants.”

Zaslavskiy will be sentenced soon in his criminal case, but it looks like his civil matter is over with.

Blockchain Mining Supply and Services LTD v. Super Crypto Mining, Inc. and DPW Holdings, S.D.N.Y., 1:18-cv-11099, 11/28/2019 [SDP]

Here’s a case that would warm the cockles of a contract law professor’s heart. New tech, a sale contract, mitigation after breach it’s like Hadley v. Baxendale meets Blade Runner. If I didn’t scare you away yet, read on.
 
This new lawsuit in New York federal court involves alleged breach of contract involving an asset purchase for 1,100 Bitmain Antminer S9 miners and 1,100 power supply units for $3,272,500 on March 8, 2019. Plaintiff says it agreed to sell the units and that Super Crypto agreed to buy them.

Plaintiff alleges — remember these are allegations, not proven — that Defendant paid for first 500 and they were released from storage. Repeated promised were allegedly made to pay storage charges and the full balance, per the Complaint. The complaint details small payments that were made through spring, summer and fall of 2018. Then “on October 11, Defendants wrote to Plaintiff, calculated the outstanding balance to be $1,566,375, and stated they wanted to 'Pay the outstanding balance, avoid any legal action, and we are anxious to receive the machines so we can place them to work.'” 

Plaintiff says they finally got fed up and gave notice of their intent to sell the remaining 600 machines and recoup the difference from defendants. Here’s the kicker, “On or around November 9, 2018, Plaintiff resold the remaining 600 Machines to a third party for the fair market price of $168,000, a price that reflected the decline in the cryptocurrency market between the time that the Agreement was signed and the time that Plaintiff resold the Machines.” In short, Plaintiff held onto the miners for so long that they were no longer worth the sale price owed by the Defendants. That’s the rub.

In a further twist — almost a law school fact pattern — Plaintiff says that the two defendants are effectively alter egos of one another and that DPW is essentially is the same thing as “Super Crypto Mining.” My assumption is that Super Crypto is cash poor and the Plaintiff sees a greater likelihood of recovery from DPW.

The resolution of this case is going to turn on pretty mundane contract law and UCC issues. What were defendants contractual obligations? Did plaintiff properly mitigate? Was the sale price fair. This is almost straight out of a law school exam.