Discussions surrounding the legal risks of initial coin offerings (ICOs) typically focus on the risk of regulatory action for failure to comply with securities laws. While securities regulatory risks are significant, and compliance with securities legislation is essential, it is also important to emphasize that entities conducting ICOs - and the individuals leading or promoting them - may also be significantly exposed to civil claims, including class actions. This class action risk is considerably heightened by the large amounts being raised through ICOs in 2017 - over $3.25 billion globally as of mid-October 2017.
The Tezos class action
A class action lawsuit filed in late October 2017 arising out of an ICO for the Tezos project highlights the class action risk for ICOs. The Tezos project aims to develop a blockchain-based platform for smart contracts similar to Ethereum. In July 2017, Tezos raised over $230M USD in an ICO. In October 2017, Reuters reported a dispute between the two founders of the Tezos project and the president of the Swiss foundation established to conduct the Tezos ICO. Progress on the Tezos project has apparently been delayed as a result. On the heels of those reports, the futures price for the not-yet-released Tezos token fell significantly, and various U.S. law firms announced they were investigating potential claims relating to Tezos and other ICOs.
These developments have culminated in a class action filed in the California courts on behalf of all “natural persons” (i.e., individuals, not companies) that purchased tokens in the Tezos ICO. The complaint names as defendants the Swiss foundation established for the Tezos ICO, the U.S. company that owns the Tezos intellectual property, the president of the Swiss foundation, the two founders of the Tezos project and a public relations firm that allegedly assisted in the promotion of the ICO.
The claims alleged in the complaint are based on unregistered offer and sale of securities, fraud in the offer or sale of securities, false advertising and unfair competition. In addition, the claim pleads an alter ego theory of liability to attempt to make all defendants, including the individual defendants, liable. Among other things, the claim alleges that the defendants misrepresented the relationships between the defendants, how the funds raised during the ICO would be spent, the adoption of Tezos by well-known companies, and the time to complete the Tezos project.
The typical ICO model
The typical ICO has many features that may make claims relating to an ICO suitable for a class action. Typically, an ICO will unfold as follows:
- The project team publishes a white paper describing a project and the team’s intention to issue tokens to support the development of the project. The white paper typically describes the goals and technical aspects of the project, the composition of the project team, advisers to the project team and the intended use of the ICO proceeds.
- The ICO is advertised through various channels, though many projects rely heavily on social media and other online advertising.
- Depending on the structure, either the company carrying out the project or a related non-profit entity receives Bitcoin, Ether or, in some cases, fiat currency from those interested in participating in the ICO and issues tokens in exchange.
- The tokens are issued subject to written terms and conditions, which, depending on the precise structure, may describe the transaction as a purchase or a gift.
- After issuance, the tokens can be traded on a cryptocurrency exchange or peer-to-peer.
- The value raised through the issuance of tokens is used to advance the project.
Class action risk
The essence of a class action is commonality - that is, the existence of issues that are common to a class of claimants. As a result, the typical ICO lends itself to potential class certification. Where identical tokens are issued to a group, each of whom may have reviewed the same white paper, agreed to the same terms and conditions and will be affected in the same way by the success or failure of the project, there may be sufficient commonality for a class action on behalf of token holders to be certified. The likelihood of certification will depend on the facts of the particular ICO and the nature of the claims being advanced in each case.
Plaintiffs bringing claims in connection with an ICO may attempt to rely on a variety of legal theories:
- Corporate and Securities Laws – As the Tezos class action demonstrates, corporate and securities laws typically provide for civil remedies available to security holders, such as remedies for failure to comply with securities laws, the making of misrepresentations, or unfair disregard of a security holder’s interests. To the extent a token falls within the definition of a security under applicable legislation, token holders may have claims under such legislation.
- Negligent Misrepresentation/Civil Fraud - Any false or misleading statement contained in the white paper or otherwise published to token holders could be the basis for a claim for misrepresentation under laws other than securities law. In some circumstances, a failure to disclose information may be a misrepresentation. Token holders may be able to claim damages or void the transaction if they acquired tokens in reliance on a misrepresentation.
- Breach of Contract – Typically, tokens are issued subject to written terms and conditions. Although some projects describe the transaction as a gift, a court may find that the transaction is in fact a contract of sale. If the transaction was a contract and there were commitments made regarding what the project would accomplish or how value received would be used, a failure to comply with those terms could be the basis for a breach of contract claim.
- Breach of the Duty of Good Faith – If a token holder is in a contractual relationship with the token issuer, the issuer may owe a duty of good faith to the purchaser. False claims or other dishonest conduct during the performance of the contract, such as false or misleading statements about the status of the project, could be a breach of this duty.
- Breach Fiduciary Duty / Negligence - Depending on the precise structure and the law governing the entity that receives the value contributed during the ICO, the directors, officers, trustees or other principals of this entity may owe fiduciary and other duties to those that provided the value, i.e., token holders. To the extent those principals do not act in the best interests of the token holders, they may well be personally exposed to claims by the token holders. Even if they are not fiduciaries, entities or individuals responsible for raising value through an ICO or making decisions about how to deploy the proceeds may well owe a duty of care to those who provided the funds. If poor decisions are made, or the funds are not safeguarded properly, these individuals may well be exposed to negligence claims. Properly safeguarding the proceeds of an ICO from cyber attacks is particularly critical given the targeting of ICOs and cryptocurrency generally by hackers.
- Misleading Advertising & Consumer Protection Laws - Many ICOs make extensive use of social media advertising (e.g., Instagram and Facebook ads). To the extent advertisements contain false or misleading statements, there may be civil liability under laws against misleading advertising. More generally, consumer protection laws often provide civil remedies for misrepresentation or other unfair practices in consumer transactions. Consumer protection laws may extend liability to parties and circumstances where common law claims may not be tenable. Consumer protection laws may also override limitations or exclusions of liability contained in the terms and conditions pursuant to which tokens are issued.
A further factor bearing on the litigation risk associated with ICOs is that many are made in connection with early-stage projects, which generally have a significant risk of project failure. Anecdotally, token holders are often retail investors who may not appreciate these risks or take steps to appropriately mitigate them. This can be contrasted with traditional investors in early-stage projects, such as venture capitalists, who generally understand the high level of risk and become actively involved in their investee companies.
Risk mitigation strategies for ICOs
It is common for there to be an attempt to mitigate legal risk through various contractual mechanisms in the terms and conditions used in a ICO, such as limitation of liability clauses, disclaimers of representations, mandatory arbitration clauses, class action waivers and clauses relating to choice of law, venue and jurisdiction. The enforceability of these terms, particularly against consumers, is unclear and will in any event vary by jurisdiction.
Some projects conducting ICOs have chosen to structure their offering using legal entities in Switzerland or other jurisdictions viewed as friendlier to cryptocurrency and ICOs. Whatever the regulatory advantages, this does not necessarily prevent the entities - or the individuals involved in the ICOs - from being sued in courts in jurisdictions where token holders reside, as the recent Tezos class action demonstrates.
Still other projects have taken the position that their tokens are not securities. Regardless of whether or not this position has merit as a matter of securities law, it does little if anything to address risks under other legal theories described above. In fact, if an ICO project team is successful in convincing securities regulators that the tokens they plan to sell are not securities, that may simply bring the tokens more squarely within consumer protection legislation along with exposure to oversight by different regulators and to legal action under different statutes.
The conversation around the legal risks of ICOs has tended to focus on securities regulatory risk. Although this is undoubtedly a critical legal issue for projects considering ICOs, it is far from the only legal issue that needs to be addressed. Entrepreneurs, advisors and promoters involved in ICOs need to be aware of the risk of potential claims, including class action claims, by token holders, particularly as these claims may expose individuals involved in an ICO to personal liability.