The popularity of cryptocurrencies and initial coin offerings (ICOs) has risen so dramatically that this year Merriam-Webster added definitions for both phrases to its most recent edition. In light of the wave of regulatory actions and private litigation that has followed ICOs—a wave that is sure to accelerate—it is perhaps more than a coincidence that Merriam-Webster's newest edition also added the phrase “dumpster fire.”

Some innovative companies have sought to use ICOs as a new method to raise capital. In an ICO, a company will offer a coin or token in exchange for fiat currency or other cryptocurrencies, which provide capital to the company or fund specific projects.

One key issue plaguing cryptocurrency regulation is the application of Great Depression-era securities regulations—and private class action lawsuits based on those regulations—to a modern, rapidly developing technology. For over 80 years, the SEC and the courts have consistently used the Howey test—first established by the U.S. Supreme Court in the 1940s—to determine what activities fall under federal securities laws, see SEC v. W.J. Howey, 328 U.S. 293 (1946). Under the Howey test, an instrument is considered a security if: a person invests money; in a common enterprise; with the expectation of profits; and solely from the efforts of others. In light of this construct, SEC Chairman Jay Clayton recently testified before the Senate that “I believe every ICO I've seen is a security,” despite the fact that “not one” of these ICOs has been subjected to the registration requirements of the Securities Act and the Exchange Act. As the chairman implied, actual application of securities laws to ICOs by courts has been slow to develop, but it is increasingly picking up speed.

Enforcement Actions

The SEC first weighed in on ICOs when a decentralized, autonomous organization known as “The DAO” sought to sell tokens to fund “projects” to produce earnings for investors. The SEC concluded The DAO's tokens were securities subject to the requirements of federal securities law. Ultimately the SEC chose not to bring charges or make any findings of violation against The DAO, but used the opportunity to inform both issuers and investors that, under certain conditions, crypto-currencies may be securities and thus subject to federal securities laws.

Once issuers were on notice of the potential application of securities laws, the SEC initiated enforcement actions. To date, the SEC has commenced a handful of enforcement actions in federal court, bringing charges against both ICO issuers and issuers' officers, see EC v. REcoin Group Foundation, No. 17-cv-05725 (E.D.N.Y. Sep. 29, 2017); SEC v. Plexcorps, No. 17-cv-07007 (E.D.N.Y. Dec. 1, 2017); SEC v. AriseBank, No. 18-cv-00186 (N.D. Tex. Jan. 25, 2018); SEC v. Sohrab Sharma and Robert Farkas, No. 18-cv-02909 (S.D.N.Y. Apr. 2, 2018). In these actions the SEC has generally targeted ICO issuers by enforcing the registration requirements under Sections 5(a) and 5(c) of the Securities Act as well as the anti-fraud provisions laid out in Section 10(b) of the Exchange Act, Section 17 (a) of the Securities Act, and various rules thereunder. Some of the SEC's civil actions have also been accompanied by criminal prosecutions initiated by the local U.S. Attorney's Office. Recently, the SEC reportedly issued subpoenas to approximately eighty ICO issuers in the course of conducting nonpublic investigations. While there is a strong possibility these subpoenas may lead to more enforcement actions, the fallout has yet to be determined.

The SEC has pursued administrative remedies against one ICO issuer—informing the issuer on the second day of its ICO that the unregistered sale of its tokens violated Sections 5(a) and (c) of the Securities Act, see In re Munchee, SEC Release No. 10445, File No. 3-18304 (Dec. 11, 2017). The issuer immediately canceled the ICO and returned all proceeds to investors. The SEC issued an administrative cease-and-desist order but imposed no penalties and took no further action against the issuer.

State governments, such as Massachusetts, Texas and New Jersey, have also begun to take regulatory action against unregistered ICOs in their states, as in In re Caviar and Kirill Bensonoff, Commw. of Mass. Office of the Sec'y of the Commw. Sec. Div., Docket No. 3-2017-0120 (Jan. 17, 2018); In re Bitcoiin, N.J. Bureau of Sec. (Mar. 7, 2018). These state securities regulatory actions have typically sought cease-and-desist orders through administrative proceedings to prevent the further sale of unregistered tokens.

Private Civil Litigation

In addition to civil SEC enforcement actions, the private plaintiffs' bar—purportedly on behalf of investors in ICOs—has been very active as of late, bringing numerous civil class action claims against ICO issuers in state and federal court. By recent count, at least a dozen private securities cases have been filed in the last six months alleging various violations of securities law related to actual or contemplated cryptocurrency offerings. Critically, these cases have been brought against companies large and small, start-up and established, and unfortunately have every indication of being the beginning of a much larger litigation wave to come.

Many of the federal claims mirror the SEC charges, alleging that the ICOs were unregistered securities and/or were sold based on fraudulent statements or omissions in violation of Sections 5(a) and (c) or 17(a) of the Securities Act, see, e.g., GGCC v. Dynamic Ledger Solutions, No. 17-cv-06779 (N.D. Cal. Nov. 26, 2017). ICO investors have also sued companies for the sale of unregistered securities under Section 12(a)(1) of the Securities Act, and targeted control persons of the issuers under Section 15(a) of the Securities Act, see, e.g., Stormsmedi v. Giga Watt and Giga Watt, PTE, No. 17-cv-00438 (E.D. Wash. Dec. 28, 2017). Unlike the SEC, however, to prevail on their fraud claims private plaintiffs must allege and ultimately prove that they relied on false or misleading representations or omissions by ICO issuers and that those representations or omissions caused damages. Although the majority of ICO claims are in federal court, many investors have also brought state and common law based claims for false advertising, unfair competition, deceptive and unfair practices, and violations of state securities laws.

In light of the U.S. Supreme Court's recent decision in Cyan v. Beaver County Employees Retirement Fund permitting some claims under the Securities Act to be brought in state courts (as well as federal courts, which have exclusive jurisdiction of Exchange Act cases), we expect to see a surge in state court filings asserting that ICOs contain materially false information, see e.g., Wildes v. Bitconnect International PLC, No. 18-cv-80086 (S.D. Fla. Jan. 24, 2018).The first movements in this shift appear to be materializing, as a federal judge in the Northern District of California, citing Cyan, recently issued an order to remand back to California Superior Court a Securities Act-based ICO claim originally filed in that court, as in Baker v. Dynamic Ledger Solutions, No. 17-cv-06850 (N.D. Cal. Apr. 19, 2018). In doing so, the judge not only permitted the Securities Act-based claim to return to state court, but also ordered the remand despite the fact there would be parallel state and federal proceedings with the potential for contradictory outcomes. As a result, the Cyan ruling not only gives plaintiffs a choice of forums in Securities Act claims, but potentially allows for multiple concurrent actions regarding the same ICO—an outcome that not only leads to the potential of inconsistent rulings, but certainly will increase the cost of defending this type of litigation.

In addition to civil claims based directly upon an ICO, some companies have been sued under Section 10(b) and Rule 10b-5 for misrepresentations or omissions made to traditional stockholders regarding the companies' intent to engage in an ICO or the impact of the ICO on the existing stockholders. In one such case, even though no tokens were issued, shareholders claim they were harmed by the plummeting of the company's stock after the company canceled its ICO in response to SEC inquiries, see, e.g., Morris v. Overstock.com, No. 18-cv-00271 (D. Utah Mar. 29, 2018).

Future of ICO Litigation

While much of how the existing law applies to ICOs remains an open question, ongoing private and government civil and criminal actions will help to flesh out the application of long-standing legal concepts to the novel issues raised. One case to watch is United States v. Zaslavskiy, No. 17-CR-00647 (RJD) (E.D.N.Y. Nov. 21, 2017). in which the defendant filed a motion to dismiss, arguing that cryptocurrencies are not securities. Although the SEC's and DOJ's stance on this issue is clear, this case will likely be the first time the issue is squarely addressed by a federal judge—albeit in a criminal context—and (depending on the outcome) the resulting decision and similar decisions by other courts in the coming months may embolden or chasten the SEC and investors in how they seek to apply securities laws to ICOs.

Classification is not the only key issue facing courts, as some issuers have sought to enforce an arbitration clause in the ICO's terms and conditions as a means of avoiding court proceedings altogether, see Davy v. Paragon, No. 18-cv-00671 (N.D. Cal. Jan. 1, 2018). If ICO issuers are successful in this effort, the continuing viability of class action claims by ICO purchasers could be significantly diminished (although this would not limit suits brought by existing shareholders). In addition, the geographical fluidity of most ICOs raises novel issues relating to the extra-territorial reach of the U.S. securities laws in light of recent U.S. Supreme Court cases curtailing that reach.

Merriam-Webster may want to prepare now for some dictionary definitions as a result of the various legal proceedings against ICO issuers: Rescission-token, crypto-bail-bond, and Settlement Fork are all distinct possibilities. And more troubling, ICO issuers need to prepare for the existing and accelerating onslaught of private litigation and government regulation (both federal and state) directed at the burgeoning cryptocurrency economy.

Nicolas Morgan is a partner in the Investigations and white collar defense practice at Paul Hastings and based in the firm's Los Angeles office. He focuses his practice on complex securities litigation in state and federal courts and representations involving government investigations and white-collar crime allegations levied against individuals and businesses.

Douglas H. Flaum, a partner in the litigation practice of Paul Hastings, serves as co-chair of the firm's securities litigation practice. Flaum has litigated cases on behalf of domestic and foreign corporations, directors, and special board committees in a diverse range of areas related to complex financial and business arrangements.

Nate Brown is an associate in the litigation practice and is based in the firm's Los Angeles office. His practice focuses on civil litigation, securities litigation, and white collar defense.