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Cryptocurrencies and Fraud Claims: A Short Primer

What keeps both Janet Yellen and Kim Kardashian up at night? If you guessed cryptocurrencies, you are up on your news. While Kim Kardashian was raking in influencer money for promoting Ethereum Max, a popular digital token traded on crypto exchanges, Janet Yellen and other regulators (among others, the Securities and Exchange Commission [SEC] and Commodity Futures Trading Commission) have been testifying over the summer before the U.S. House of Representatives, asking for investor protection on crypto exchanges.

According to the Federal Trade Commission (FTC), crypto scams are on the rise, with consumers reportedly losing nearly $82 million during the 4th quarter of 2020 and the 1st quarter of 2021 alone. While lawmakers try to get up to speed about this burgeoning and somewhat murky industry, litigators are not waiting for the lawmakers to act.

A full discussion of the technology behind cryptocurrencies is beyond the scope of this Practice Pointer, but it is worth noting that due to the use of “blockchain” technology by most cryptocurrencies, and related blockchain “mining,” whatever fraud may arise in crypto-related transactions will not likely be at the level of cryptocurrency ownership.

The transparent system of continual verification and logging by “miners” in the blockchain system (a digitized, decentralized public ledger of transactions) works to ensure protection against fraudulent transactions by way of its own continuity.

Although cryptocurrency ownership may be relatively secure from claims of fraud, the investment industry that has emerged from the “cryptosphere” has become a potential source of federal and state law fraud actions. There have been a number of recent enforcement actions by the SEC and state regulators relating to securities fraud and alleged unregistered sales of securities backed by cryptocurrencies. There have also been a number of private lawsuits brought by investors against investment companies formed to purchase cryptocurrencies alleging securities fraud, common law fraud and breach of contract.

While there have been few reported cases involving cryptocurrencies, a recent 11th Circuit opinion gives a flavor of the kinds of the fact patterns one might encounter as well as a warning that would-be plaintiffs in private securities fraud litigation need to be aware of statutory limitations periods.

In Fedance v. Harris, 1 F. 4th 1278 (11th Cir. 2021), the 11th Circuit affirmed a trial court ruling dismissing claims by a purchaser of unregistered securities in an initial coin offering of cryptographic tokens promoted by celebrities to fund a movie-streaming platform. The tokens were created specifically by the defendants for purposes of fundraising for the platform, and investors were promised they could “redeem” the tokens after the offshore entity that issued them launched. Fedance, 1 F. 4th at 1282.

After positive social media promotion and celebrity endorsement, the tokens began trading on a crypto exchange for several months at promising valuations. The defendants, however, missed deadlines to launch the streaming service, and the value of the tokens ultimately crashed in value to next to nothing. Id. The plaintiff — who had purchased $3,000 worth of tokens — filed a putative class action claim against the defendants under the Securities Act of 1933, alleging that the defendants had sold unregistered securities in violation of federal law.

The trial court dismissed the plaintiff’s complaint, finding that it was filed beyond the one-year limitations period under the Act. The 11th Circuit Court affirmed the trial court’s ruling, reasoning that neither the “discovery rule” nor “equitable tolling” applied to plaintiff’s statutory claims. Fedance, 1 F.4th at 1286–87.

In addition to security-based fraud cases, common themes in recent private litigation relating to cryptocurrencies include allegations that the investment firm defrauded its investors either by failing to purchase cryptocurrencies with the invested funds, or that the firms committed errors in their investment strategies. With an influx of new crypto exchanges on the market, and the increased stakes of capturing market share (cryptocurrencies are gaining traction as accepted forms of payment with large corporations like Paypal, Coca-Cola and Restaurant Brands International), Sherman Act and related state law fraud and unfair competition suits are likely on the horizon.

And, despite the impressive security protocols associated with blockchain mining, one large computer hack at an exchange firm could lead to a whole host of lawsuits involving fraud, breach of contract, and breach of fiduciary duty claims.

Contact George F. Ritchie with any questions about this topic.

George F. Ritchie co-authored this article with Alex Harmon, an intern in the firm’s Litigation practice.

 

George F. Ritchie
410-576-4131 • gritchie@gfrlaw.com

Editor’s note: This article was originally published by the American Bar Association on September 30, 2021.

 

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Date

11.02.21

Type

Publications

Authors

Ritchie, George F.

Teams

Litigation