Fraud Suit Verdict Undermines SEC Control of Cryptocurrencies

Crypto Regulation

A lawsuit over an alleged crypto Ponzi scheme dating back to 2014 may have thrown a big wrench into the U.S. Securities and Exchange Commission’s argument that nearly all cryptocurrencies are securities over which it has authority.

In a ruling that gives “cryptocurrency market participants some much-needed and rarely received comfort,” according to the law firm Troutman Pepper, a federal jury in Connecticut found that four digital assets and products related to a cryptocurrency mining operation were not “investment contracts” subject to state and federal securities laws.

The verdict in “Audet v. Fraser” “will have wide-reaching implications” for two reasons, Troutman argued in a Nov. 22 blog post.

“First, Audet involved four very different crypto products similar to many other crypto or crypto-related products on the market,” it said. “Accordingly, some issuers of such products may conclude that, if litigated, their products would not be considered ‘securities’ and, therefore, not subject to state and federal securities laws. It may strengthen their resolve to litigate or resist enforcement.”

Second, it has the potential to “change the balance of power” between the SEC and the cryptocurrency issuers it has been suing for selling what the agency contends are unregistered securities for several years. In many cases, the agency has forced companies that sold cryptocurrencies in initial coin offerings (ICOs) to pay large fines to avoid litigation — which can be destructive well before a verdict is reached.

Troutman pointed to the SEC’s lawsuit against messaging service Telegram’s TON blockchain project, which had raised $1.7 billion in an ICO of “Grams” cryptocurrency. A court blocked the project pending the outcome of a suit in which the judge concluded that the “SEC has shown a substantial probability of success in proving” that Grams were securities. The litigation threatened to stall the project so long that Telegram was forced to drop it, acquiescing to the agency’s demand that it return $1.2 billion to TON buyers and pay an $18.5 million fine.

Also see: Telegram Consents to $18.5M SEC Penalty

Since then, only one company, Ripple, has been willing to fight the SEC, saying the case has “broader implications” for the entire cryptocurrency industry. A Ripple spokesperson declined to comment on the Audet ruling.

Related news: Ripple CEO Confident SEC Lawsuit Moving in Right Direction

The SEC has sued a number of cryptocurrency issuers for selling unregistered securities over the past four years.

Gary Gensler, the SEC’s new chairman, recently announced that he considers nearly all cryptocurrencies sold in ICOs to be securities. “It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities,” he said in an Aug. 3 speech at the Aspen Security Forum. “These products are subject to the securities laws and must work within our securities regime.” The reason, he said, is that “generally, folks buying these tokens are anticipating profits.”

Asked about the Audet verdict, an SEC spokesperson said the agency declined to comment.

No Ruling on Fraud

The Audet v. Fraser class-action lawsuit revolved around a firm called GAW Miners, which the plaintiffs alleged sold shares in the returns of a hardware mining farm, first offering “Hashlets” that entitled buyers to a share of the cryptocurrency mined by the operation, and then selling “Hashpoints,” which could be converted into a digital currency called “Paycoin” that would be held in digital wallets called “HashStakers.”

The plaintiffs accused GAW Miners’ principals, Homero Joshua Garza and Stuart A. Fraser, of selling far more Hashlets than its hardware actually produced. Next, they said, the pair launched Hashpoints, promissory notes convertible into Paycoin, which could be locked into HashStakers wallets for up to six months in exchange for fixed returns. When the price of Paycoin began to plummet, buyers were trapped by the HashStakers lockup.

The plaintiffs’ civil case revolved around these actions violating the U.S. Securities Exchange Act of 1934 and the Connecticut Uniform Securities Act (CUSA). To do that, the plaintiffs had to prove that some or all of the Hashlets, Hashpoints, HashStakers, and Paycoin were investment contracts — a term that covers stocks, bonds, and other types of securities.

Whether an investment is a security is determined by the Howey rule, which was established by the Supreme Court in 1934. That defined a security as an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”

The jury found that none of the four products was a security, so it never ruled on the merits of fraud accusations.

Troutman argued that in the wake of the Audet verdict, “courts may be less inclined to find that a plaintiff has a ‘substantial probability of success’ in proving that a certain digital asset or product is a security under Howey.”