Web3 vs. U.S. Securities Law
Securities Litigation and Its Application to Crypto and Web3 - a Brief Primer
In the United States of America, private securities enforcement predominantly takes place through class-action litigation in the federal courts, encompassing most private securities class actions under Sections 11 and 12 of the Securities Act and Sections 10 and 14 of the Exchange Act. These proceedings are predominantly 'lawyer-driven', and class-action lawyers usually derive their fees from settlements, or the recovery obtained at the action's conclusion. For investors and entrepreneurs in the crypto and web3 space, the class-action landscape underscores the critical need for compliance with federal disclosure regulations and understanding the risk of exposure to collective legal actions. The development of blockchain technology, decentralized finance (DeFi), and web3 applications can generate unique legal complexities and create an environment in which failure to disclose material facts can result in litigation. So, in order to provide some basic context of what securities litigation looks like in the U.S., and how it might provide exposure for web3 builders, investors, and service providers, we have this brief primer:
Obstacles to Private Claimants: Absence of a Private Right to Sue and Standing Requirement
One considerable impediment to private claimants seeking remedies is the frequent absence of a private right to sue, except in well-established areas like claims of fraud under Section 10 of the Exchange Act. Recent federal court decisions have typically been reluctant to imply new private rights of action where Congress has not explicitly provided one.
An additional barrier that plaintiffs face is demonstrating standing to sue, varying depending on the specific statutory provision. For example, to bring an action under Rule 10b-5, a plaintiff must show that they bought or sold securities in the transaction being complained of. These obstacles do not apply to the Securities and Exchange Commission (SEC), which can bring actions on behalf of the government under all provisions of the securities laws.
For crypto and web3 entrepreneurs, these barriers can be both a defense and a concern. A robust understanding of standing requirements and private rights of action can inform both corporate strategy and risk management.
Disclosure-Based Securities Laws and the Importance of Materiality
Federal securities laws primarily focus on disclosure rather than contract law. This requires that plaintiffs bear the burden of proving an issuer, seller, or buyer traded securities based on a material misstatement or omission. The definition of materiality, as established in TSC Industries, Inc v. Northway, Inc., requires a substantial likelihood that a reasonable investor would deem the fact significant in decision-making.
This emphasis on disclosure and materiality has profound implications for crypto and web3 enterprises, where information symmetry and transparency are often challenging to maintain. Clear and factual disclosure becomes a vital legal consideration, and companies must avoid vague or misleading statements, especially in areas like whitepapers, roadmaps, and public communications.
Restrictions on State Law and the Impact of Cyan Decision
Under the Securities Litigation Uniform Standards Act (SLUSA), plaintiffs are barred from asserting certain securities fraud claims under state law. The Supreme Court's decisions in Cyan, Inc. v. Beaver County Employees' Retirement Fund and others have led to an increased complexity of navigating between federal and state jurisdictions. These developments have spawned a boom in state litigation, particularly in New York and California, and raise significant questions regarding the importation of federal procedural restrictions into state forums.
For crypto and web3 projects, the jurisdictional complexities and the post-Cyan explosion in state litigation signify an evolving legal landscape that requires close monitoring. Ensuring compliance with both federal and state laws and recognizing the potential for overlapping litigation can aid in risk mitigation.
Strategies to Contain State Litigation and the Relevance to the Crypto Space
Defendants have taken various approaches to contain the surge in state litigation, such as adopting forum-selection provisions and staying state proceedings in favor of first-filed federal actions. Recent decisions from New York appellate courts indicate a careful application of federal precedent.
In the rapidly expanding crypto and web3 space, these legal developments offer both challenges and opportunities. Being aware of and leveraging these mechanisms can be instrumental for businesses navigating the multifaceted U.S. securities laws. Adaptation to evolving legal landscapes, combined with proactive risk management, is essential for sustained growth and innovation in this dynamic sector.
Impact on Investors and Entrepreneurs in the Crypto and Web3 Space
Strict Liability under Section 11 of the Securities Act
Section 11 plays a critical role in investor protection. The broad scope of liability—extending to issuers, directors, accountants, underwriters, and others connected with the registration statement—emphasizes the gravity of maintaining accurate disclosure. In the crypto and web3 space, this has significant implications. Entrepreneurs in these realms must exercise exceptional diligence in preparing registration statements, aware that inaccuracies may result in strict liability.
For investors, Section 11 provides a robust shield against material misstatements or omissions. Since crypto assets and web3 applications can be highly technical and opaque, investors often rely heavily on the information provided in registration statements. The lack of a requirement to prove reliance on misstatements or bad faith on the part of the defendant enhances their legal protection.
The Omnicare Decision and Its Implications
The Supreme Court’s ruling in Omnicare further refines the interpretation of Section 11. It sets an intriguing precedent by differentiating between misleading opinions and statements of fact. Crypto and web3 companies, whose technologies often involve novel, untested, and speculative elements, may issue opinions regarding future potential or technological capabilities. Following Omnicare, these companies must ensure that any opinions they express in registration statements are consistent with the information they possess at the time, or else explicitly disclose the tentative nature of their beliefs.
Section 12: Liability for Unregistered Sales and Misleading Prospectuses
Section 12 has profound implications for the crypto space, particularly regarding Initial Coin Offerings (ICOs) and other token sales. These provisions emphasize the need for proper registration and truthful prospectuses, adding another layer of accountability for issuers.
Entrepreneurs must be aware that non-compliance with registration requirements or issuance of misleading prospectuses can lead to liability. Meanwhile, investors in crypto and web3 products have legal remedies should they encounter false or misleading information or purchase unregistered securities.
Exchange Act: Section 10 and Rule 10b-5
The provisions under Section 10, notably Rule 10b-5, represent some of the most powerful tools against securities fraud in the United States. They cover a broad array of fraudulent activities, including insider trading and making material misstatements.
For the rapidly evolving and often opaque crypto and web3 space, these provisions create an environment of enhanced scrutiny. Entrepreneurs must exercise utmost care in their communications and trading practices, aware that both intentional fraud and material misstatements or omissions can lead to liability.
The complex jurisprudence around the reliance element and the 'fraud-on-the-market' theory further enriches the landscape. Class action lawsuits under Rule 10b-5 might become relevant in cases of widespread market manipulation or significant misrepresentations affecting the price of crypto-assets.
Recent Supreme Court Rulings
Decisions like Halliburton Co. and Goldman Sachs Group significantly impact how securities fraud claims, including those related to crypto and web3 products, might be litigated. These rulings provide nuanced guidance on how price impact must be proven and the importance of the nature of misrepresentations.
Given the often-volatile pricing and unique characteristics of crypto-assets, these rulings may lead to complex litigation scenarios where both sides will engage in in-depth economic analyses to demonstrate or refute price impact.
Extension of Traditional Securities Law to Crypto Space
The broad reach of insider trading laws, including those rooted in Rule 10b-5, demonstrates the legal challenges faced by the crypto space. While the application of these regulations to traditional securities is well-established, the landscape becomes complex and nuanced when it comes to cryptocurrencies, tokens, and decentralized platforms. Key considerations include:
Definition of Security: The classification of crypto assets as securities, and the application of rules pertaining to unregistered and delisted securities, create uncertainty and potential legal liabilities. Recent regulatory focus has aimed to delineate between utility tokens and investment contracts, but clarity is still a work in progress.
Scope of Insider Trading: The decentralized nature of many crypto platforms challenges traditional notions of insiders and fiduciary duties. The question arises whether developers, miners, or influential community members might fall under the ambit of insiders or temporary insiders. Legal boundaries in this area are still being explored.
Tender Offers and Mergers: Provisions related to untrue statements and fraudulent acts in connection with tender offers (Section 14(e)) may affect takeovers and mergers in the crypto space. The courts' approach to negligence versus scienter can influence the required level of intent, leading to different levels of potential liability.
Cryptocurrencies and the Misappropriation Theory
The misappropriation theory's application to crypto and web3 might broaden the scope of insider trading liabilities. This theory could apply to situations where confidential information is used for trading within decentralized networks or platforms. The legal responsibility might extend to developers, community members, or even automated bots in some scenarios.
The Special Case of Decentralized Finance (DeFi)
DeFi is a segment of the crypto industry that aims to recreate traditional financial systems on decentralized networks. The unique challenges include:
Governance Tokens and Voting: Proxy rules such as Rule 14a-9 might apply to governance tokens that give holders voting rights in decentralized organizations. The requirements for disclosures and the prohibition of false or misleading statements could significantly affect how DeFi projects communicate with token holders.
Compliance with Anti-Fraud Rules: Procedures like Rule 14e-3(a) and Section 14(e) could be applicable to DeFi protocols that facilitate or replicate traditional tender offers or mergers. Ensuring compliance in a decentralized environment poses unique challenges and risks.
Technological Considerations and Enforcement
The technology underlying crypto and web3 adds complexity to enforcement. Anonymity, borderless transactions, and decentralized structures can obscure identities and jurisdictions. How regulators will adapt enforcement mechanisms to address these challenges is a key concern.
The Way Forward: Need for Legal Clarity
The intersection between traditional securities law and the burgeoning crypto and web3 space presents an intricate legal landscape filled with potential pitfalls and opportunities. As the industry matures and legal precedents are set, there is an increasing need for specific regulatory guidance tailored to the unique characteristics of these innovative technologies.
Entrepreneurs and investors must navigate this evolving legal framework with caution and awareness of the underlying complexities. Engaging legal expertise in the crypto space, staying abreast of regulatory developments, and building compliance into business models will be vital to operating successfully within these new frontiers.
Settlements, Damages, and Remedies: Impact on Investors and Entrepreneurs in the Crypto and Web3 Space
Settlements
Securities lawsuits are most often resolved through settlements rather than proceeding to trial. This is particularly true for class actions where judicial approval is required in line with Federal Rule of Civil Procedure 23 (Rule 23). The courts scrutinize settlements to ensure they are 'fair, reasonable, and adequate,' taking into consideration various factors including the complexity and cost of litigation, and the risk-reward calculus of going to judgment.
The propensity to settle securities claims could have significant implications for investors and entrepreneurs in the crypto and Web3 space. As the sector continues to mature and become more regulated, it is likely to attract greater scrutiny from regulatory bodies. Consequently, crypto and Web3 companies may face increased litigation risks, mirroring those seen in traditional securities markets.
For crypto and Web3 investors and entrepreneurs, the readiness to settle might be a double-edged sword. On the one hand, settlements can provide a quicker resolution, often avoiding the uncertainty and publicity of a trial. On the other hand, the potential for large settlement payouts can have chilling effects on innovation and investment in the space, particularly for startups that may lack the resources to engage in protracted legal battles.
Damages and remedies
The remedies and damages applicable to common securities claims have a broad scope, encompassing monetary losses, rescission, injunctive relief, and disgorgement of profits. These remedies can be exacting and may have far-reaching impacts on the entities involved.
In the crypto and Web3 context, these damages and remedies take on particular significance. The rapid and sometimes volatile price fluctuations associated with cryptocurrencies and digital assets may complicate the assessment of 'actual damages.' The decentralized nature of many crypto and Web3 projects might make the identification of responsible parties and the enforcement of judgments more challenging.
The availability of rescission as a remedy might be particularly relevant for initial coin offerings (ICOs) and other token sales, allowing investors to undo transactions that may have been based on misleading or insufficient information.
Implications for the Crypto and Web3 Space
Increased Legal Complexity: As the legal landscape continues to evolve, crypto and Web3 companies must navigate complex regulations that may not have been designed with their unique characteristics in mind. Compliance requires significant legal expertise and resources.
Potential Chilling Effect on Innovation: The threat of securities litigation and the associated costs of settlements or damages may deter innovation and investment within the crypto and Web3 space, particularly for smaller companies and startups.
Enhanced Focus on Compliance: The potential legal risks reinforce the need for crypto and Web3 companies to focus on robust compliance programs. They must establish clear internal policies, investor communication strategies, and due diligence procedures to mitigate these risks.
Investor Protection and Confidence: On the positive side, clear rules and enforcement mechanisms can foster investor protection and confidence in the crypto and Web3 markets. It might lead to a more sustainable and responsible growth trajectory for the industry.
Global Considerations: Crypto and Web3 often transcend national borders. The international nature of these technologies and markets requires an understanding of not just domestic regulations but also international laws and treaties. The interplay between different legal systems adds another layer of complexity.
Reshaping the Future of Finance: The application of traditional securities laws to the rapidly evolving crypto and Web3 space represents an ongoing challenge and opportunity. It brings into focus questions about how existing legal frameworks can adapt to new technological realities. This adaptation process could reshape the future of finance, leading to a more integrated and inclusive global financial system.
Conclusion
The application of securities laws, particularly as they pertain to settlements, damages, and remedies, has profound implications for investors and entrepreneurs in the crypto and Web3 space. It underscores the importance of legal compliance, risk management, and thoughtful navigation of a complex regulatory landscape. As the legal contours continue to take shape, they will undoubtedly influence the trajectory and maturity of this innovative and transformative sector. The dialogue between regulators, practitioners, entrepreneurs, and investors will be critical in forging a legal framework that both protects consumers and fosters innovation in the era of decentralization.
What kind of lawyer would I be without a disclaimer?
Everything I post here constitutes my own thoughts, should only be used for informational purposes, and does not constitute legal advice or establish a client-attorney relationship (though I am happy to discuss if there is something I can help you with). I can be reached via email at dlopezkurtz@crokefairchild.com or david@bsl.group on telegram @davidlopezkurtz on twitter @lopezkurtz and on LinkedIn here.