Cryptocurrency, like any investment, carries risks. For one, there is the risk that the cryptocurrency decreases in value.[1] There is also a risk of more fundamental issues: the issuer misrepresenting material aspects of the cryptocurrency[2] or even simply running away with investors’ money.[3] For these issues, most investment products have well established legal remedies.[4] For example, an issuer who makes a material misrepresentation to investors about a security could, under federal securities laws, face private litigation.[5] For cryptocurrency investors, however, the scope of legal recourse available is not often clear.[6] This is the case because it is not often clear how to classify any given cryptocurrency in the first place.[7]
Classification of a specific cryptocurrency determines the applicable federal and state laws.[8] In trying to identify the applicable laws, the problem is that opinions differ on how to classify any given cryptocurrency, even federal agencies have taken divergent approaches.[9] For instance, the IRS treats cryptocurrency as property (like any other equity investment),[10] the SEC treats many cryptocurrencies as securities,[11] and the CFTC treats Bitcoin and some other products as commodities.[12] This has resulted in conflicting regulatory schemes.[13] For instance, if the cryptocurrency is treated as a security, the federal securities laws will apply and agencies that enforce those laws, i.e. the SEC, can bring an enforcement action.[14] By contrast, if the cryptocurrency is treated as a commodity, the federal laws that govern commodities will apply and agencies, i.e. the CFTC, can bring an enforcement action.[15]
Since private litigants often look to the actions of federal agencies when planning their own litigation strategies, this patchwork regulatory approach can make it difficult for private litigants to figure out how to classify the disputed cryptocurrency.[16] Further complicating this issue is the fact that there are no guidelines or general processes by which federal regulators formally pre-classify a cryptocurrency product before it is issued to investors.[17] This means that private litigants who hope to sue a cryptocurrency’s issuer take their best guess as to the appropriate classification, sue under the potential classification’s applicable laws, and hope the judge agrees with them.[18] If the judge disagrees, the lawsuit will be dismissed.[19]
Litigants typically do not file suits surrounded by so much uncertainty of the applicable statutory and regulatory regimes. For most other litigants, this issue simply would not arise. For instance, a homeowner whose contract for a home renovation was breached can easily figure out, with the help of her lawyer, which contract laws will govern their lawsuit. Similarly, a pedestrian injured by a reckless driver can easily figure out which tort laws will provide the best avenue of relief. By contrast, a cryptocurrency investor who lost his investment to someone else’s wrongdoing will have a lot more trouble figuring out which laws to sue under.[20]
The lack of a unified federal regulatory approach is compounded by the absence of a universal framework at other levels of government (from the federal judiciary, legislature, or executive branch and from most of the several states) to assist investors in determining how to classify cryptocurrency products.[21] That is, there is no widely accepted judicially created test for determining classification, no legislation to proactively classify the various cryptocurrencies, and limited guidance from federal agencies.[22] Investors must attempt to find imperfect analogies and convince a judge that the specific cryptocurrency conforms with their suggested classifications.[23] This is inefficient because investors and issuers end up spending lots of time, effort, and money squabbling over which laws apply rather than getting to the merits of the dispute.[24] If there was an intuitive framework available for issuers to quickly and easily figure out how to classify the product at issue before starting the litigation, it would save time and effort.
Currently, the most readily advanced path to an established framework appears to be through the judiciary.[25] Since cryptocurrencies are such a new phenomenon, there is not a long history of court cases involving private litigants suing issuers.[26] But there are some, and an exponentially increasing number are winding their way through the courts.[27] It may not be long before there is a judicially-created test or framework to assist litigants in determining how to classify their cryptocurrency product.
Most of these lawsuits allege that the cryptocurrency product at issue is a security.[28] This is likely because the Securities Act of 1933 provides a broad private right of action for investors of a security so, naturally, a cryptocurrency litigant wants the cryptocurrency product at issue classified as a security so they can avail themselves of that private right of action.[29] Additionally, there is a well-established test for determining whether a financial product is a security: the Howey test.[30] Over the past few years, the SEC has used the Howey test successfully to demonstrate that certain cryptocurrency products are securities and therefore fall under its jurisdiction.[31] Subsequently, some private litigants have used the Howey test to convince several judges that the cryptocurrency product they are suing over is a security.[32]
Another possible approach for private litigants is to try to classify the cryptocurrency as a commodity.[33] In the past few years, the CFTC has convinced at least two federal judges that certain cryptocurrencies are commodities and thus subject to the Commodity Exchange Act (CEA).[34] The CEA includes a private right of action that could be attractive to private litigants.[35] Currently, at least one class of private litigants is trying to convince a federal judge that certain cryptocurrency derivatives are commodities so that they can avail themselves of the protections of the CEA.[36]
These are just two potential classifications. Between the two, it is likely that the Howey test will encapsulate a greater number of cryptocurrencies.[37] This is reflected in numerous recent lawsuits, which argue that the products at issue meet the Howey test.[38] If, as these lawsuits play out, judges generally agree that these products are securities, it could provide some predictability and precedent for subsequent investor lawsuits. However, every cryptocurrency is unique, and classification will remain a close call.
While case law is created in the judiciary, it remains to be seen if federal agencies or Congress will take greater action to fill the gaps and provide more guidance on classification for the continuously increasing number of cryptocurrency investors.[39] Federal agencies have been fairly tepid about regulating cryptocurrency even though some cryptocurrencies, such as Bitcoin, have been around for over a decade.[40] For instance, it was not until a massive Ethereum hack in 2016 caused investors to lose $50 million in a single day that the SEC began to seriously scrutinize cryptocurrencies; The SEC released its first memo summarizing their position and policies on cryptocurrencies.[41] Although there is some progress, the SEC is very slow to craft regulations governing cryptocurrencies.[42] Instead, as discussed above, it has tried to use existing laws as the basis for bringing enforcement actions against cryptocurrency issuers.[43] As the SEC continues to find success in this approach, it is using the securities laws to go after increasingly bigger issuers.[44] Late last year, for example, the SEC filed a lawsuit against Ripple, a company that has sold tokens now cumulatively worth $22 billion.[45] Cases like these, even though they are brought by a federal agency, can still create important case law which can guide private litigants on classification issues.
But leaving federal agencies and private litigants to fight cryptocurrency fraud with securities and commodities laws that were never intended to apply to cryptocurrencies does not seem like a viable long-term solution.[46] Gary Gensler, the soon-to-be new SEC chairman for the Biden administration, has suggested that it is far better to engage in regulation now while regulators and legislators have time to carefully analyze and implement proposed solutions.[47] This would be preferable to waiting until there is some sort of cryptocurrency crisis, where regulators would then undoubtedly be pressured to rush regulations into existence without taking the time to give them careful thought and fully consider their consequences.[48] Promulgating regulations now could provide further clarity for private litigants by supplementing the continuously developing caselaw.
Although the SEC and the CFTC have been at the forefront of the debate over classifying cryptocurrencies, it should be noted that state attorneys general are starting to play a more active role.[49] State case law provides some guidance to cryptocurrency investors who intend to sue under state laws.[50] However, this patchwork approach only underscores the necessity of unified federal guidance.[51] All fifty states, with the innumerable inconsistencies of their individual laws, will never provide unified guidance to investors.[52] Instead, it seems far more reasonable to expect a unified approach from the federal government.[53] While the current approach of patchwork guidance, or lack thereof, from different federal agencies may be an inevitable result of dealing with an entirely new financial phenomenon, investors will surely demand a unified approach to classifying cryptocurrencies. It is inevitable that, whether through further developments in the caselaw or through unified federal regulations, the dispute of how to classify the various cryptocurrencies will eventually be settled. For the growing number of cryptocurrency investors, that day cannot come soon enough.
[1] Ryan Browne, Two-day bitcoin sell-off wipes out over $100 billion from the entire crypto market, CNBC (Jan. 21, 2021), https://www.cnbc.com/2021/01/21/bitcoin-btc-price-falls-wiping-off-100b-from-entire-crypto-market.html.
[2] Press Release, SEC, SEC Obtains Emergency Asset Freeze, Charges Crypto Fund Manager with Fraud (Dec. 28, 2020), https://www.sec.gov/news/press-release/2020-341.
[3] Jamie Bartlett, Cryptoqueen: How this woman scammed the world, then vanished, BBC (Nov. 24, 2019), https://www.bbc.com/news/stories-50435014.
[4] William Savitt & Noah B. Yavitz, The Secs. Litig. Rev. 267, 270-78 (William Savitt, ed. 2017).
[5] Id.
[6] Charles Toutant, Growing Litigation Niche Tackles Suits on Behalf of Unhappy Cryptocurrency Traders, Law.com (Oct. 14, 2020), https://www.law.com/njlawjournal/2020/10/14/growing-litigation-niche-tackles-suits-on-behalf-of-unhappy-cryptocurrency-traders.
[7] Press Release, CFTC, CFTC Backgrounder on Oversight of and Approach to Virtual Currency Futures Markets (Jan. 4, 2018), https://www.cftc.gov/sites/default/files/idc/groups/public/%40customerprotection/documents/file/backgrounder_virtualcurrency01.pdf.
[8] Jacob Gottlieb, Cryptocurrency and Blockchain Litigation and Regulatory Enforcement, Morrison Cohen LLP (Nov. 20, 2018), https://www.morrisoncohen.com/siteFiles/files/Cryptocurrency%20and%20Blockchain%20Litigation%20and%20Regulatory%20Enforcement%20-%20Gottlieb%20-%20LexisNexis%20-%20November%202018.pdf (explaining that whether the SEC or CFTC has jurisdiction over a cryptocurrency product hinges on whether the product at issue is considered a commodity or a security).
[9] See infra notes 10-12 and accompanying text.
[10] Press Release, IRS, Virtual currency: IRS issues additional guidance on tax treatment and reminds taxpayers of reporting obligations (Oct. 9, 2019), https://www.irs.gov/newsroom/virtual-currency-irs-issues-additional-guidance-on-tax-treatment-and-reminds-taxpayers-of-reporting-obligations.
[11] Framework for “Investment Contract” Analysis of Digital Assets, SEC, https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets (last visited Feb. 22, 2021).
[12] Retail Commodity Transactions Involving Certain Digital Assets, 85 Fed. Reg. 37,734 (June 24, 2020) (to be codified at 17 C.F.R. pt. 1).
[13] See supra notes 10-12 and accompanying text.
[14] Blockchain & Cryptocurrency Regulation 2021, Glob. Legal Insights, https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/usa (last visited Feb. 11, 2021).
[15] Retail Commodity Transactions Involving Certain Digital Assets, 85 Fed. Reg. at 37,735 (Aug. 2, 2018).
[16] Gottlieb, supra note 8 (describing the patchwork approach and how private lawsuits have been brought under a variety of different federal and state laws).
[17] CFTC, supra note 7.
[18] Complaint at 24, Toomey v. Ripple Labs, Inc., No. 21-cv-00093 (M.D. Fla. Jan. 25, 2021), ECF No. 1 (arguing that Ripple’s XRP tokens are securities and should be analyzed under federal securities law).
[19] Motion to Dismiss at 20, In re Ripple Labs Inc. Litigation, No. 18-cv-06753 (N.D. Cal. Jan. 15, 2020), ECF No. 70 (arguing that the suit should be dismissed because the cryptocurrency product at issue is not a security).
[20] Gottlieb, supra note 8 (noting that private litigants must figure out “is cryptocurrency a security? A commodity? A currency? Something else? Does it matter how it is used? Is it . . . a case-by-case test?”).
[21] Blockchain & Cryptocurrency Regulation 2021, Glob. Legal Insights, https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/usa (last visited Feb. 11, 2021).
[22] Id.
[23] See Gottlieb, supra note 8 (providing an overview of the different approaches taken in various cryptocurrency class actions).
[24] Charles Toutant, Growing Litigation Niche Tackles Suits on Behalf of Unhappy Cryptocurrency Traders, Law.com (Oct. 14, 2020), https://www.law.com/njlawjournal/2020/10/14/growing-litigation-niche-tackles-suits-on-behalf-of-unhappy-cryptocurrency-traders (describing some of the difficulties faced by private litigants).
[25] Id.
[26] Id.
[27] For example, on April 6, 2020 alone, eleven cryptocurrency-related lawsuits were filed in the Southern District of New York. Kevin LaCroix, Plaintiffs File a Slew of Cryptocurrency-Related Securities Suits, The D&O Diary (April 7, 2020), https://www.dandodiary.com/2020/04/articles/securities-litigation/plaintiffs-file-a-slew-of-cryptocurrency-related-securities-suits.
[28] Gottlieb, supra note 8 (noting that most cryptocurrency class actions allege violations of the federal securities laws).
[29] Id.
[30] SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
[31] SEC v. Kik Interactive Inc., 2020 U.S. Dist. LEXIS 181087, at *13 (S.D.N.Y. Sep. 30, 2020).
[32] Solis v. Latium Network, Inc., No. 18-10255 (SDW) (SCM), 2018 WL 6445543 (D.N.J. Dec. 10, 2018); Rensel v. Centra Tech, Inc., No. 17-24500-civ-King/Simonton, 2018 U.S. Dist. LEXIS 106642 (S.D. Fla. June 25, 2018).
[33] Gottlieb, supra note 8 (listing a few cryptocurrency class actions that allege violations of the Commodity Exchange Act).
[34] CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018); CFTC v. My Big Coin Pay, Inc., 334 F. Supp. 3d 492 (D. Mass 2018).
[35] 7 U.S.C. § 25.
[36] Complaint at 63, Williams v. HDR Global Trading Limited, No. 20-cv-02805 (S.D.N.Y Apr. 30, 2020), ECF No. 1.
[37] The Howey test covers securities (of which many cryptocurrency products share attributes) whereas the CEA covers derivatives (which account for only a small portion of cryptocurrency products).
[38] In 2019, at least 100 private cryptocurrency-related lawsuits were filed alleging violations of the securities laws. LaCroix, supra note 29.
[39] Ephrat Livni, What’s Next for Crypto Regulation, N.Y. Times: DealBook (Jan. 30, 2021), https://www.nytimes.com/2021/01/30/business/dealbook/crypto-regulation-blockchain.html.
[40] Id.
[41] Reno Varghese, The Possible Regulatory Gap in Future ICO Class Action Litigation, Colum. Bus. L. Rev. Blog (Nov. 18, 2020), https://journals.library.columbia.edu/index.php/CBLR/announcement/view/365.
[42] Livni, supra note 39.
[43] See supra notes 30-31 and accompanying text.
[44] Nathaniel Popper, Cryptocurrency Company Ripple is Sued by S.E.C., N.Y. Times (Dec. 21, 2020), https://www.nytimes.com/2020/12/21/technology/ripple-cryptocurrency-sec-lawsuit.html.
[45] Id.
[46] Livni, supra note 39.
[47] Id.
[48] Id.
[49] Wick Sollers, Cryptocurrency Crackdown, Am. Bar Assoc. (Feb. 5, 2019), https://www.americanbar.org/groups/litigation/committees/criminal/practice/2019/cryptocurrency-crackdown.
[50] Timothy G. Massad, It’s Time to Strengthen the Regulation of Crypto-Assets 34-36 (Brookings Institute, Working Paper, 2017), https://www.brookings.edu/wp-content/uploads/2019/03/Timothy-Massad-Its-Time-to-Strengthen-the-Regulation-of-Crypto-Assets-2.pdf.
[51] Id.
[52] Id.
[53] Id. at 35-37.
