Cryptocurrencies prove contentious

Arthur Piper, IBA Technology CorrespondentTuesday 20 September 2022

As the world of finance continues to wrestle with exactly what to make of cryptocurrencies, it’s the litigators making a mint.

With turmoil rife in the traditional global economy – both in the wake of the pandemic and fuelled by the war in Ukraine – digital currencies are also feeling the heat. As Global Insight recently reported (see Crypto-catastrophes and executive orders, IBA Global Insight June/July 2022) the stablecoin Terra and its sister cryptocurrency Luna crashed out of the market during May, in what was described by one pundit as ‘one of the greatest catastrophes crypto has ever seen’. Luna’s value sky-dived from $116 in April to zero by mid-May with the supposedly dollar-pegged Terra hitting about 15 cents at the same time.

While the worth of holdings in Terra and Luna were almost wiped out, even the most well-established cryptocurrencies are struggling. The value of a single Bitcoin, for example, peaked in October 2021 at $61,374.28, according to the analyst Statista. At time of writing, its price had fallen by over 60 percentage points to just below $20,000. That means that any investor that piled cash into Bitcoin after November 2020 and held on to it has lost money.

Popular delusions

Compared with company shares, there’s little in the way of valuable real estate, machinery, supply chain networks, sales and customers holding up cryptos’ values. In fact, there’s no agreed way of accurately measuring how much to pay for such digital assets, so fluctuations of crypto value often depend on the sentiment of the crowd. And, ever since Charles Mackay penned his classic work, Extraordinary Popular Delusions and the Madness of Crowds in 1841, it has been clear that where there’s little intrinsic value in an asset, bubbles form – and burst.

Yet, despite the Terra and Luna crash, there are signs that the values of the largest products are beginning to normalise a little. Even without standardised measurements, Bitcoin and other mainstream crypto-style assets are beginning to regularly track stock market values. For example, the recent decrease in Bitcoin’s price to below $19,000 in September 2022 came after the US Federal Reserve Chairman, Jerome Powell, flagged further rises in interest rates. And as bad news continues to dominate the headlines – including of stagflation, war and the climate crisis – both crypto and shares have fallen.

This normalisation points to an expectation that crypto will play a prominent role in the world’s monetary system. As recently as 2021, bodies as august as the World Economic Forum (WEF) argued that cryptocurrencies were ‘democratising finance’. Given that about a third of the world’s population must survive without access to a bank account – including 22 per cent of people in the US – cryptocurrencies potentially provide anyone with a phone a gateway to the financial tools many in the developed world take for granted. That was one of the stated aims of Facebook’s cancelled Libra project.

‘It is not inconceivable to imagine that in the coming decades, the world will have a much more democratised and accessible financial system’, said the WEF in an article for its Davos Agenda 2021. ‘Financial inclusion could be achieved thanks to cryptocurrencies.’

Democratisation by lawsuit

That will be of little comfort to small-time investors caught up in the rush to capitalise on the rollercoaster ride associated with the failures of some cryptocurrencies. Many who have publicly described their losses say they lost life savings and faced homelessness due to the Terra and Luna crash.

Yet, ironically, these events are creating a different kind of democratisation: the emergence of a new wave of class action lawsuits against those in the crypto sector. The US is the leader in this field because the legal nature of cryptocurrency products is better defined there than in most jurisdictions – which means there are clearer legal channels for redress when things go wrong.

The US Securities and Exchange Commission (SEC), for example, has increasingly taken the view that cryptocurrencies are securities – a position reinforced by its decision to name nine cryptocurrencies as securities in an ongoing case in which it alleges insider trading against a former Coinbase employee, alongside two others (all deny the allegations). While this classification is contested by the industry, it enables plaintiffs to apply the well-established Howey test to a crypto asset to determine its legal status.

‘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’, wrote Christopher Halm in the Fordham Journal of Corporate and Financial Law in 2021. ‘Subsequently, some private litigants have used the Howey test to convince several judges that the cryptocurrency product they are suing over is a security.’

The Howey test defines ‘a security’ as comprising four elements: an investment of money, a common enterprise, a reasonable expectation of profit and that it’s derived from the efforts of others. Since the SEC has acknowledged there to be many flavours of crypto, not all will pass the Howey test. But, in making these moves, the regulator has also made the overall direction of travel clear: the burden of proof will fall on crypto developers to show that their products are not securities.

In June, attorneys filed a class action lawsuit in the US following the collapse of Terra and Luna against Terraform Labs and various other parties, citing federal securities laws as their basis. Other groups of claimants are suing too. Coinbase, the crypto exchange, is also facing class actions after the SEC announced it was investigating whether the platform had improperly categorised its assets: in other words, Coinbase had not classed them as securities. The defendants are, of course, contesting the claims in all these matters.

But it’s not just coin creators and the exchanges that make and deal in cryptocurrencies that face such actions – the tentacles of legal disputes are stretching further into the sector’s business world. For example, celebrities such as Kim Kardashian and boxer Floyd Mayweather are facing legal challenges over their advertising or promotion of an Ethereum derivative product called EthereumMax. While investors piled into the product, according to the court filing, EthereumMax’s value rocketed – then subsequently crashed, leaving millions of people out of pocket. EthereumMax, which is also named in the suit, has stated that ‘The deceptive narrative associated with the recent allegations is riddled with misinformation about the EthereumMax project […] We dispute the allegations and look forward to the truth coming out.’ Similarly, all defendants in the case refute the allegations.

‘There’s been a steady stream of cases from regulators, but what’s really exploded is private litigation’, according to Jason Gottlieb, Chair of the White Collar and Regulatory Enforcement practice group at US law firm Morrison Cohen. The firm, which tracks the sector, said that crypto-based class action lawsuits were up by 50 per cent since the beginning of 2020. Large law firms have been scrambling to recruit partners and associates to deal with this new influx of work. And, as the rules become better defined and the targets for litigation more clearly identifiable, the legal infrastructure around cryptocurrencies is likely to become more lucrative – whatever the value of the underlying assets may turn out to be.

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