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7 Tough Legal Lessons for Crypto Entrepreneurs

Stephen Palley is a lawyer in private practice in Washington, D.C. with the firm of Anderson Kill. The views expressed are his alone. You can find him on Twitter at @stephendpalley.

One day you’re a crypto-millionaire, the next you’re a crypto-defendant.

Initial coin offerings (ICOs) made crypto-news throughout 2017. Announcements of new offerings became a flood as winter turned to spring and then summer.

As 2017 closed, an assortment of ICO litigation has followed.
What’s the good news? If I am making lemons out of lemonade, we will have more clarity from regulators and courts.

Some might argue that the clarity was already contained in the rules and cases but the abstraction has been made real by the mistakes of others. And it you’re a crypto-entrpreneur in 2018, this is a good thing.

For lawyers, some of what follows may be Captain Obvious territory, but here are seven observations:

The long arm of the law really is long

Think being in Switzerland can stop you from getting served with a U.S. lawsuit? Nope.

And very nope if you use email, Twitter or LinkedIn.

In one of the half-dozen Tezos lawsuits, the plaintiff asked to serve the lawsuit on Swiss defendants using email (the Tezos Foundation and Diego Ponz), email and Twitter (Johann Gevers), and email and LinkedIn (Guido Schmitz-Krummacher, Bitcoin Suisse AG and Niklas Nikolajsen).

The court said yes, finding that:

“Plaintiff has shown (1) the Swiss Defendants are not within any judicial district of the United States; (2) service by electronic means is not prohibited by any international agreement, (3) service by the electronic means specified below comports with constitutional notions of due process and is reasonably calculated to apprise the Swiss Defendants of the pendency of the action and afford [them] an opportunity to respond.”

After this order was entered, the parties entered into an agreement by which they asked the court to vacate the order in exchange for the defendants appearing in the case, while reserving all objections to jurisdiction and service.

The tactic had the effect of getting a bunch of Swiss defendants to quickly appear in a U.S. lawsuit. And it shows that a federal judge believes that international social media service is acceptable, which is quite something. (See also Blockchain Jurisdiction, by yours truly).

Scammers gonna scam

If it was a scam before Satoshi conceived bitcoin, it’s still a scam today.

If you’re a recidivist securities law violator who promises a 1,000 percent plus return on investment in less than a month and doesn’t actually do anything with the money that you raise from investors other than renovate your house, the SEC is likely to come calling. (See, for example, Plexcoin).

This isn’t really ICO litigation – it’s a securities fraud enforcement action where the alleged fraudsters happened to use ICO lingo to raise money.

Lawyers can read

Regulators and class action lawyers know how to read! As someone pointed out in a blog post last year, everything that you write is evidence  – your white paper, tweets, Slack channel, etc.

And as that someone predicted, ICO lawsuits quote liberally from all of these sources. Like, think actual screenshots from Slack in lawsuits.

It’s called a ‘statute of limitation’

Litigation and regulatory enforcement actions take time. Just because you haven’t gotten a subpoena from The Man in the month since your decentralized cheese token went live, it doesn’t mean you won’t.

Coinbase’s tangle with the IRS is a case in point, ultimately addressing accounts in existence between 2013 and 2015. This doesn’t mean that the IRS isn’t going to go after accounts from 2015 to 2017, it just means that they take their sweet time, as do other agencies.

It’s a courtroom, not Twitter

What gets you likes on crypto Twitter doesn’t work in Court.

One of my favorite reported cases from 2017 is a late-December New York State Supreme Court (that’s a trial court) decision that addressed a challenge to New York’s BitLicense regulations. (The case is Chino v New York Dept. of Fin. Servs., 2017 N.Y. Misc. LEXIS 5153, Dec. 21, 2017).

The plaintiff filled out a partial application, but did not include most of the required information and asked for a waiver of the $5,000 application fee.

According to the Court, he “filled out some but not all financial information on the form requested, and he indicated that he had no insurance and kept no financial or accounting books.”

For his background report certification, he wrote: “[Could] not obtain in time.” He also demanded the depositions of Paul Krugman and former New York Department of Financial Services superintendent Benjamin Lawsky.

Apparently, “but bitcoin” was not good enough for the court, which threw his lawsuit out (and rejected the deposition requests).

Create governance or it’ll be created for you

I see companies operating on different sides of the spectrum here.

In some cases, people completely dispense with corporate formalities, raise money and then effectively hope for the best.

Don’t be that company.

If you create governance, understand it

It turns out that creating a Swiss foundation to raise hundreds of millions of dollars in an ICO doesn’t mean you can actually use the money.

While this would be no surprise to lawyers involved in creating the things, a Swiss foundation is “an autonomous legal entity.”

Here’s a court filing that says exactly this:

What does it mean to create an “autonomous” corporate entity? It means that you may not really control it!

And as a practical matter, this means that the Tezos founders can’t directly access the $1.3 billion controlled by the foundation they created.

I could go on and on about Tezos (and I have, which you know if you follow me on Twitter). For now, I am going to keep it simple.

The trend of U.S. blockchain startups creating Swiss foundations is over. It makes no more sense than a Swiss startup incorporating a U.S. non-profit in Hackensack, N.J.


So what are my predictions for 2018?

I think flying cars are still a couple of years off, but I do expect to see more litigation over botched ICO governance, judgment collection that tangles with private keys, and a healthy lump of workout-related legal work — that is, fixing businesses that have significant assets but did things the wrong way.

A year from now we will have more precedent, more guidance from the mistakes of others, and maybe even a few genuine successes.

Disclosure: CoinDesk is a subsidiary of Digital Currency Group, which has an ownership stake in Coinbase.

Law book and gavel image via Shutterstock

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Just the Beginning? What the Tezos Lawsuits Mean for ICO Litigation

While startups launching initial coin offerings (ICOs) may be all too aware they’re working in a legal gray area, that might not be enough to stop lawsuits that could test their legality.

At issue is that, although the U.S. agency tasked with enforcing securities law – the U.S. Securities and Exchange Commission (SEC) – has voiced concerns about cryptocurrency tokens (even labeling one a security), it has yet to announce much in the way of formal rules.

But while the SEC would have bearing on criminal lawsuits, courts hearing civil suits aren’t necessarily constrained or dictated by the SEC’s lack of a formal position on ICOs. Instead, these courts would make decisions based on their prior rulings and the specific circumstances of a case.

But what would that decision be? That question hinges on another: What makes an ICO a security or something else? Although attempts to interpret existing law have been made, it’s unclear even to those in the know.

Now, following the news that Tezos, one of the largest most visible startups yet to use the ICO funding mechanism, has been hit with two lawsuits, it seems lawyers and litigators are lining up to press the issue, potentially with the aim of a payday in mind.

Sara Hanks, CEO of CrowdCheck, a consultancy that assists entrepreneurs and investors with crowdfunding campaigns, told CoinDesk:

“We know of a number of plaintiffs’ lawyers around the country who are just basically collecting lists of ICOs and going ‘Hmm, I’m going to sue these people.'”

And the interest seems to be coming from lawyers working in similar sectors where a mix of lax regulation and bad actors have created the conditions for both suits and abuse.

Jaspar Ward, a partner at Louisville-based Jones Ward, which has filed class actions against fantasy sports services, sought to stress that he sees ICOs as an area of interest for precisely those factors.

“We see this as the next area where consumers could get harmed by some bad actors taking advantage of the lack of oversight or by pushing the envelope,” Ward said.

Casting a wide net

And according to some, Tezos is the prototypical defendant for such a lawsuit.

While the ideas underlying the project itself date back to the earliest days of blockchain (the white paper it’s based on has been in progress since 2014), the company has clear ties to the U.S. (which aids lawyers in the collectability of rewarded funds) and has attracted a significant number of buyers to its sale.

Dynamic Ledger Solutions, for instance, is a Delaware-based company that holds Tezos’ intellectual property and the source code for its yet-to-be-developed technology.

“The ICO most appealing to a plaintiff lawyer would be large in terms of total money raised, have a strong U.S. nexus, would have promoters and participants in the ICO who are U.S.-based, and the tokens that it would issue would reflect a claim on the share of the company’s future revenue,” explained Joel Fleming of Block & Leviton, adding succinctly:

“Tezos certainly checks a lot of those boxes.”

As chronicled by CoinDesk, the allegations against Tezos include both fraud and the sale of unregistered securities, though it’s the latter that may be most notable here.

The idea is that civil lawsuits from disgruntled token holders may force the SEC’s hand outlining an official stance on whether ICOs are indeed securities, which in turn, could have ramifications that extend far beyond just Tezos.

Setting the table

In this way, the case against Tezos could set important legal precedents, and in remarks, lawyers surveyed appeared to already be thinking about how to demonstrate that token offerings like those by Tezos could be deemed securities.

According to Jake Walker, also of Block & Leviton, which has launched an investigation of its own into Tezos, proving the sale of unregistered securities pursuant to the 1933 Securities Act is “much more of a ‘check the box’ litigation” than proving fraud.

He continued, “That kind of flaunting of securities laws is something that definitely stands out to the plaintiff’s bar and to us.”

While these lawsuits could spur other ICO issuers to rethink their token scheme’s structure to shield themselves from liability, Walker believes it may be too little, too late.

“Tezos is far from the only ICO that we see that has substantial U.S. involvement and U.S. entities that would clearly be participants in the sale of unregistered securities and be potentially liable,” he said.

Others appeared to agree that this issue could be settled in court, or that at least, the incentives are there for law firms to attack the issue.

David Silver, the partner at SilverMiller in South Florida who filed the second suit yesterday against Tezos, believes his case could serve as a springboard for future ICO litigation.

“This is a leak in a dam that is about to come falling down,” he told CoinDesk.

Not so fast

But, the attractiveness of Tezos as a target doesn’t mean a judgement against them will necessarily implicate other, similar projects.

“A Delaware company changes everything,” said Silver, stressing that, with distributed technologies, proving a tie to a location could prove key for litigators.

Further, because most plaintiffs’ lawyers work on a contingency basis, meaning that they are paid a percentage of the judgments they win on behalf of clients, they tend to shy away from cases where recovering funds awarded could be problematic – such as when companies are sheltered overseas.

Since there are more foreign-registered ICOs than U.S-based ones, lawyers might see the opportunity cost as too high and move on to other things.

“It gets significantly more complicated when they are overseas or foreign entities,” said Fleming. Plus, “in terms of collectability, it’s a bit more difficult given that most of the ICOs are raising their money not in fiat currency but in bitcoin or ether.”

And of course, a class action lawsuit against an ICO requires finding enough dissatisfied token holders who want to pursue legal recourse.

Silver concluded:

“At one point in time, I said into a camera that I planned on filing 30 (class actions against ICOs) in 30 days. I have since walked that statement back because finding ICOs to whom we can sue and collect has been harder than I anticipated.”

Law image via Shutterstock

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Disclaimer: This article should not be taken as, and is not intended to provide, investment advice. Please conduct your own thorough research before investing in any cryptocurrency.